Welcome to the Chapter on Aggregate Supply (AS)!

Hello future economists! We've already looked at Aggregate Demand (AD)—the total spending in the economy. Now, we turn to the supply side: Aggregate Supply (AS). This is where firms decide how much they are willing and able to produce.

Why is this important? AS determines the economy's potential. Understanding AS helps us analyze crucial macroeconomic problems like inflation, unemployment, and economic growth. Mastering this chapter is key to understanding macro policy!

Don't worry if the concepts of the "Short Run" and "Long Run" seem abstract at first. We will use simple steps and analogies to make them crystal clear.

Section 1: Defining Aggregate Supply (AS)

1.1 What is Aggregate Supply?

Aggregate Supply (AS) is the total planned output of goods and services firms are willing and able to produce in an economy at a given price level and time period.

Think of AS as the sum of all production decisions made by every firm—from the local coffee shop to the largest car manufacturer—in the entire country.

Key Distinction: When we analyze AS, we must split our view into two different timeframes: the Short Run and the Long Run.

Did you know? The way the AS curve is shaped is one of the biggest points of debate between different schools of economic thought (like Classical and Keynesian economists)!

Quick Review: Key Terms
  • AS: Total output of the economy.
  • Short Run: Period where at least one factor of production (usually labour wages) is fixed or "sticky."
  • Long Run: Period where all factors of production and costs are fully variable and flexible.

Section 2: Short-Run Aggregate Supply (SRAS)

2.1 Understanding the SRAS Curve

The Short-Run Aggregate Supply (SRAS) curve shows the relationship between the economy's overall price level and the total output (Real GDP) firms will supply, assuming input prices (like wages) are fixed.

Shape: The SRAS curve is upward sloping (it goes up and to the right).

2.2 Why is the SRAS Upward Sloping? (The Profit Incentive)

This is a crucial concept. Here is the step-by-step logic:

  1. The Price Level Rises: The general price level for goods and services in the economy increases (e.g., the price of a hamburger or a new car increases).
  2. Revenue Increases: Firms earn more revenue from sales.
  3. Costs are Sticky: In the short run, many input costs—especially wages, which are often set by annual contracts—do not immediately rise. These input costs are considered sticky.
  4. Profit Margin Rises: Since revenue goes up and costs stay temporarily fixed, the profit margin for firms increases.
  5. Output Rises: To take advantage of the higher profits, firms increase their production, leading to a higher level of Real GDP.

Analogy: Imagine you run a bakery. The price of bread suddenly goes up, but you are locked into a 3-month contract with your flour supplier and your staff wages are fixed for now. You immediately produce more bread because it's highly profitable!

2.3 Movements Along vs. Shifts of the SRAS Curve

A common mistake to avoid:

  • Movement Along SRAS: This happens only when the Price Level changes. As the price level moves up or down the Y-axis, we move along the existing SRAS curve.
  • Shift of SRAS: This happens when a non-price factor affects the costs of production.
    • A decrease in costs shifts SRAS to the right (more can be supplied at every price level).
    • An increase in costs shifts SRAS to the left (less can be supplied at every price level).

2.4 Determinants (Shifters) of SRAS

Anything that changes a firm's cost of producing one unit of output (unit labour costs, raw material costs, etc.) will shift the SRAS curve.

Memory Aid: T.I.C.S.

T - Taxes and Subsidies (Indirect Taxes)
I - Input Prices (Costs of production)
C - Currency/Exchange Rates (Affects imported input costs)
S - Supply Shocks (External, sudden events)

Let's look at the key determinants:

  1. Changes in Wage Rates (Labour Costs):
    • If wages increase (e.g., successful union negotiation), firms' costs rise, shifting SRAS left.
    • If wages decrease, SRAS shifts right.
  2. Changes in Commodity/Input Prices:
    • An increase in the price of oil or steel (a sudden supply shock) drastically increases transport and production costs, shifting SRAS left.
  3. Changes in Indirect Taxation and Subsidies:
    • Higher indirect taxes (like VAT or Excise Duties) increase the cost of supply, shifting SRAS left.
    • Subsidies reduce costs, shifting SRAS right.
  4. Changes in Productivity:
    • If workers become more productive, the unit cost of output falls, shifting SRAS right.

Key Takeaway for SRAS: The SRAS curve is determined by costs. If costs fall, SRAS moves right. If costs rise, SRAS moves left.

Section 3: Long-Run Aggregate Supply (LRAS)

3.1 The Concept of the Long Run

In the Long Run, all factors of production are variable, and crucially, all prices (both input costs and final goods prices) are fully flexible. This means costs can catch up to prices.

The LRAS represents the maximum possible level of output the economy can sustain without causing inflationary pressures. This is known as the full employment level of output or potential output (\(Y_f\)).

3.2 The Classical View of LRAS (The Vertical Line)

The traditional Classical (or Monetarist) view assumes that the economy will always return to its potential output level (\(Y_f\)) in the long run because prices and wages are perfectly flexible.

Shape: The Classical LRAS curve is perfectly vertical at the potential output level (\(Y_f\)).

Why is it Vertical?

  • If the price level increases, workers demand higher wages (costs rise).
  • Firms increase production temporarily (SRAS).
  • Eventually, wages catch up entirely, erasing the temporary profit gain.
  • Firms return to producing exactly \(Y_f\), regardless of the price level.

The vertical line tells us: In the long run, output is determined by the economy's resources (its capacity), not the price level.

3.3 The Keynesian View of LRAS (The Curve)

John Maynard Keynes argued that the economy could get stuck below full employment for long periods, especially during recessions, because wages can be very sticky downwards (workers resist wage cuts).

Shape: The Keynesian LRAS curve is a curve with three distinct sections:

  1. Horizontal Section (At very low output): The economy has a huge amount of spare capacity (factories are idle, many people are unemployed). If AD rises, firms can increase output significantly without increasing the price level, as they are just using up existing slack.
  2. Intermediate Section (In the middle): As the economy approaches full employment, bottlenecks start to appear (some skilled workers or specific resources become scarce). Output increases, but so do prices.
  3. Vertical Section (At maximum output): When the economy hits its absolute capacity (\(Y_{max}\)), it cannot produce any more. Output is fixed, and any further increase in demand only causes inflation.

Note for struggling students: The Classical model is simpler for explaining long-term growth, but the Keynesian model is more realistic when analyzing deep recessions (like the 2008 financial crisis) where high unemployment exists alongside stable prices.

3.4 Determinants (Shifters) of LRAS

Since LRAS represents the potential capacity of the economy, it shifts when there is a change in the quality or quantity of the factors of production (CELL).

Shifting the LRAS curve outwards (right) means the economy's potential output (\(Y_f\)) has increased. This is the goal of long-term economic growth policy.

These shifters are identical to what shifts the Production Possibility Frontier (PPF) outwards:

  1. Changes in Labour:
    • Quantity: An increase in the working population (e.g., through immigration or higher birth rates).
    • Quality: Improved education, training, and healthcare lead to higher labour productivity.
  2. Changes in Capital:
    • Increased investment in new machinery, infrastructure (roads, communications), or technology.
    • Example: Installing high-speed fiber optic cables across the country allows all firms to produce more efficiently.
  3. Changes in Land/Resources:
    • Discovery of new natural resources (e.g., oil or gas fields).
    • Better management of existing resources or climate change mitigation.
  4. Changes in Enterprise/Technology:
    • Improvements in technology (innovation) which allow resources to be used more efficiently.
    • Policies that encourage entrepreneurship and risk-taking.

Key Takeaway for LRAS: LRAS is all about the economy’s capacity and potential output (\(Y_f\)). To shift LRAS right, the government must implement Supply-Side Policies aimed at increasing the quality or quantity of resources.

Section 4: Comparing SRAS and LRAS

4.1 Summary of Key Differences

Feature Short-Run AS (SRAS) Long-Run AS (LRAS)
Time Horizon Input prices (especially wages) are fixed/sticky. All input prices and factors are fully flexible.
Shape (Classical) Upward Sloping. Perfectly Vertical.
Shape (Keynesian) Upward Sloping. A Curve (horizontal, then intermediate, then vertical).
Shifting Factors Changes in costs of production (Wages, Taxes, Raw Materials). Changes in the economy’s potential capacity (Quality/Quantity of CELL).
Policy Focus Policy targeting current costs (e.g., subsidies). Policy targeting structure (e.g., R&D spending, education).

Encouraging Phrase: You need to be comfortable drawing both the Classical (vertical) and Keynesian (curved) LRAS, as exam questions often require you to compare the two!

4.2 What if Input Prices Change? (The SRAS to LRAS Adjustment)

This explains how the short run eventually leads to the long run.

Scenario: Wages Rise Permanently

  1. Short Run Impact: Higher costs of production cause the SRAS curve to shift left (SRAS\(_1\) to SRAS\(_2\)).
  2. Real GDP Falls: Output falls, and the price level rises (stagflationary effect).
  3. Long Run Adjustment: Wait, if wages rose because demand was too high, the economy is still producing at its potential (\(Y_f\)) once the adjustment is complete.
  4. Conclusion: A rise in costs (like wages) only affects SRAS. The economy's long-run potential (\(Y_f\)) does not change unless the quality or quantity of the factors of production changes!
Quick Review Box: The Ultimate Test

Ask yourself: Does this change the structure or capacity of the entire economy forever? (LRAS Shift). Or does it just change the immediate cost of production? (SRAS Shift).