Economics (9640) | Determinants of long-run aggregate supply

Understanding the Engines of Growth: Determinants of Long-Run Aggregate Supply (LRAS)

Hello future economists! This chapter is incredibly important. While Aggregate Demand (AD) tells us what the economy wants to buy right now, Long-Run Aggregate Supply (LRAS) tells us what the economy can produce when all its resources are used efficiently.

Think of LRAS as the size of a country's economic "kitchen." If you have a small kitchen (low LRAS), you can only bake so many cakes, no matter how high the demand is. To bake more cakes in the long run, you need a bigger kitchen, better ovens, and more skilled chefs! That increase in potential is what we study here.

Mastering these determinants is key to understanding long-run economic growth. Let's dive in!

1. The Concept of Long-Run Aggregate Supply (LRAS)

What does LRAS represent?

The Long-Run Aggregate Supply (LRAS) curve shows the total planned output (Real GDP) when an economy is operating at its maximum sustainable capacity, using all its factors of production (Land, Labour, Capital, Enterprise) efficiently.

• Key Assumption: In the long run, costs of production (like wages and raw material prices) are assumed to be flexible and adjust fully to changes in the price level.
• Normal Capacity Level of Output: The position of the vertical LRAS curve represents the economy's full employment level of output or its normal capacity level of output. This is the maximum output achievable without causing accelerating inflation.

The Vertical LRAS Curve

In the standard Classical model taught at this level, the LRAS curve is drawn as a vertical straight line.

Why is it vertical? Because in the long run, output is determined purely by the quantity and quality of the factors of production (supply-side factors), not by the price level. If prices double, workers demand double the wages, keeping real output the same. The real productive potential of the economy doesn't change just because prices are higher.

2. The Fundamental Determinants of LRAS (The Factors of Production)

The fundamental determinants of LRAS are essentially anything that improves the quantity or quality of the economy's Factors of Production (Land, Labour, Capital, Enterprise).

2.1. Capital Stock and Investment

Capital Stock refers to the total amount of physical capital (machinery, factories, infrastructure, computers) existing in the economy.

• Investment: An increase in investment spending (I in AD = C+I+G+(X-M)) means firms are purchasing new machinery, building new factories, or improving infrastructure (like roads and ports).
• Impact on LRAS: More capital means workers have better tools, increasing the total output the economy can produce.
• Example: If a country invests heavily in high-speed fibre optic broadband (infrastructure), businesses become more efficient, shifting the LRAS to the right.

2.2. Technology

Technology refers to the state of knowledge and the techniques used in production. This is often the most powerful driver of LRAS.

• Innovation and R&D: New methods of production (like automated assembly lines or AI software) allow existing resources to produce much more output.
• Impact on LRAS: Better technology makes production cheaper and faster, increasing the maximum achievable output.
• Did you know? The invention of the microchip didn't just increase capital stock; it fundamentally changed how nearly every business operates, vastly increasing the productive capacity globally.

2.3. Working Population (Quantity of Labour)

This factor focuses on the *quantity* of available labour resources.

• Increase in Working Population: This can happen due to higher birth rates, increased net migration, or policies that encourage more people (e.g., older workers, women) to join the workforce.
• Impact on LRAS: More hands available to work means more goods and services can be produced.
• Common mistake to avoid: Don't confuse the 'working population' (the total number of people available to work) with 'employment' (the number actually working today). A shift in LRAS requires a change in the potential workforce.

2.4. Productivity (Quality of Labour)

Productivity measures output per unit of input (e.g., output per worker hour). High productivity is vital for sustained LRAS growth.

• Education and Training (Human Capital): Investing in better education, training programmes, and skills development improves the human capital of the workforce, making them more productive.
• Health: A healthier workforce takes fewer sick days and is more effective when working.
• Impact on LRAS: Even if the number of workers stays the same, if each worker can produce more, the economy's total potential output increases.

2.5. Enterprise and Economic Incentives

Enterprise involves the willingness of individuals to take risks, innovate, and set up new businesses. It's often called the "spark" that combines the other factors.

• Economic Incentives: Governments can influence enterprise through policies.
  • Lower Corporation Taxes: Encourages firms to retain and reinvest profits.
  • Lower Income Taxes: Increases the reward for working and risk-taking, improving attitudes towards work.
  • Deregulation: Reducing unnecessary rules and bureaucracy makes it easier to start and run a business.
• Attitudes: Positive attitudes towards risk-taking, hard work, and innovation boost entrepreneurship.
• Impact on LRAS: More entrepreneurs mean new, innovative firms are created, leading to better allocation of resources and increased competition.

2.6. Factor Mobility (Including Natural Resources)

Factor Mobility refers to how easily factors of production can move between different industries or locations.

• Occupational Mobility: How easily labour can switch jobs (e.g., a teacher retraining as a software engineer). Improving this reduces structural unemployment and makes the economy more flexible.
• Geographical Mobility: How easily labour can move to areas where jobs are available.
• Natural Resources (Land): While often overlooked, the discovery of new, viable natural resources (e.g., oil fields or rare earth minerals) increases the available stock of "Land," raising potential output.

3. The Keynesian View on Long-Run Potential

Don't worry if this seems tricky at first—this is an A-Level concept! While the Classical model assumes the LRAS is vertical, the influential economist John Maynard Keynes had a different idea.

The syllabus requires you to understand the Keynesian view that an economy can get stuck producing well below its normal capacity level of output for many years.

• The Problem: Keynesians argue that if Aggregate Demand (AD) is very low (e.g., during a deep recession), businesses won't invest or hire, even if wages fall, because they don't anticipate selling their goods.
• The Result: The economy can remain trapped in a negative output gap, operating below its true productive potential (the vertical LRAS) because there simply isn't enough demand to justify full resource utilisation.
• Policy Implication: In this scenario, government intervention (like increased spending or lower interest rates) is needed to boost AD and move the economy closer to its potential, even in the "long run."

Key Takeaway for LRAS Shifts: Whether through better technology, more skilled workers, or more efficient resource use, any policy or event that permanently increases the economy's ability to produce goods and services shifts the LRAS curve to the right, representing genuine, long-run economic growth.