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When a single producer supplies a product, we calculate their output on the basis of equivalent demand. However, think of the larger picture: let’s say the national level of supply in your country. To understand this, we need to know the aggregate supply, which is the total national output produced in an economy over a given time. This explanation will take you through the aggregate supply, the changes in the short and long-run aggregate supply, and the interaction of aggregate demand and aggregate supply. Keen to find out more? Read on!
Aggregate supply is a macroeconomic concept concerned with the total output of the whole economy.
The short-run aggregate supply curve involves two important concepts: movement along the supply curve and shift through the aggregate supply in the short run.
Movement along the supply curve occurs when the overall price level at which the product is sold changes, whilst other factors like production costs, labour productivity, and technology remain constant.
Let’s assume that a UK perfume company has its production unit in the UAE. The sale price of the perfume is £100 and the production cost according to the contract is £30 for the next year. So the profit for the company is £70.
However, there is an overall surge of 1% in the UK price level, which also increases the selling prices of perfumes to £101. Since there is a contract for production at £30 for the next year, the production cost will remain the same. This will increase the profit margin for the UK perfume company by £1.
This would result in UK companies taking advantage of the price increase by temporarily increasing their supply, leading to a movement along the supply curve.
Figure 1 shows movements along the short-run aggregate supply (SRAS) curve. If the price rises from P to P1 there will be a movement along the SRAS curve from point a to point b, leading to an increase in national output from Q to Q2. If the price falls from P to P2 there will be a movement along the SRAS curve from point a to point c, leading to a fall in national output from Q to Q1.
As we explained before, when talking about movement along the curve, the output price level is variable while the other factors stay constant. However, when there is a change in the other factors like the production costs, labour productivity, or technical progress, but the price level at which the product is sold is constant, we can see a shift in the aggregate supply curve. The shift in the curve can be to the left or to the right depending on the increase or decrease in the other factors.
The factors that affect the short-run aggregate supply in the economy include (but are not limited to):
- Price level
- Cost of labour
- Cost of raw materials
- The level of taxes and subsidies
Figure 2 shows the shifts in the SRAS curve. If the curve shifts to the right from SRAS to SRAS1 the national output increases from Q to Q2. If the curve shifts to the left from SRAS to SRAS2 the national output decreases from Q to Q1. Note that the price level remains constant as it is not a determinant of aggregate supply.
Let’s say that the price at which the UK perfume is sold remains unchanged at £100. However, the cost of production decreases to £25 due to a higher supply of labour at a low wage rate in the short run. The company decides to take advantage of this decrease and increases the production, hence increasing the supply in the economy. This results in the supply curve shifting to the right.
On the other hand, if the production cost increases to £40 due to lower employment number or an increase in material costs, the profit margin decreases to £60. Hence, the supplier will decrease the supply. This will result in the aggregate supply curve shifting to the left.
The short-run aggregate supply curve
(production costs, labour productivity, technology, etc.)
Table 1. Comparison between the movements and shifts in short-run aggregate supply.
The long-run aggregate supply is based on the idea that firms have achieved equilibrium in the long run and they are producing at their full capacity. We also assume that all other factors are used in their full capacity.
In the long run, we assume that the aggregate supply curve is vertical even if the price fluctuates as we also assume that the economy is running at its full capacity. The LRAS is vertical in the long run.
The above concept is more theoretical. Over the long run, the other factors tend to improve and the aggregate supply can improve as well assuming the price level remains constant.
The factors that affect the long-run aggregate supply in the economy include (but are not limited to):
- The amount of capital and labour.
- Productivity of capital and labour.
- The quantity of land and raw materials.
- Technological improvements.
- Economic incentives.
There is always a scope for improvement. For example, technological changes can speed up production or increase the supply of raw materials which can result in the shift of the long-run supply curve to the right. Other factors such as increased labour supply, better government policies, training, and development of labour can also expedite production. These changes result in an increase in the supply, leading the supply curve to shift to the right without increasing the price.
Similarly, if the other factors deteriorate, the LRAS can shift to the left.
Let’s examine the example of the milk supply in London. Even though the companies are producing at their full capacity and the price is not changing, there is a decrease in the number of truck drivers due to Brexit. Thus, the milk supply in the market was heavily affected and it was not reaching the end-users. This led to a decrease of milk supply in the market on a national level.
The Keynesian LRAS curve is different from the classical LRAS curve as Keynesians argue that the aggregate supply is elastic and upward sloping in the long run.
In the short run, there is scope for further production. This means production can be increased without much of an increase in price. This results in a horizontal aggregate supply curve up to point Q as figure 5 below shows.
However, as the economy approaches full capacity, going forward the aggregate demand increases and pushes the prices up making the curve bend steep upward (between points b and c). This can be due to shortages in factors of production like raw material, labour, etc. which increases the prices.
Eventually, when all hindrances are surpassed, the economy reaches its full potential to produce, and supply at its full capacity, the LRAS curve becomes vertical (from point c to point d and above).
The main determinants that influence the aggregate supply are:
However, in the case of long-run aggregate supply, the output remains unchanged even when the aggregate demand increases. Even at the higher price level, the LRAS curve remains stagnant and vertical as the firm is producing at full capacity.
The multiplier effect is the chain effect of the aggregate demand and aggregate supply. As more capital is injected into the economy, income increases resulting in an increase in aggregate demand and thus in the national output. However, this multiplier effect has certain limitations:
If the consumer's goods and services are not adequately available, the income will not be spent and will not help in the multiplier effect.
If the rotation of money in the economy is not continuous and if the investments stop, it can limit the multiplier effect.
Open trade relations can also affect the multiplier effect and can make the multiplier larger or smaller than its true value.
For the multiplier effect to work efficiently, it is assumed that employment is not at full capacity. Otherwise, it can lower the multiplier effect.
The shifts in aggregate supply affect all the major factors in the macroeconomy over the short run and long run. It can have the following effects on all the main factors determining the national output:
Increased or decreased capacity.
Increased or decreased output.
Increased or decreased economic growth.
Increased or reduced employment.
The output gap can be understood as the difference between the potential output (trend) and the actual output in the economy.
An output gap can also be understood using AD and AS.
We determine the equilibrium using the LRAS and AD1 (at point e).
When the SRAS1 is below the actual output and aggregate demand meets the SRAS1, it is below the equilibrium. This creates a negative output gap (at point a).
When the SRAS is above the actual output and the aggregate demand also increases above the equilibrium, it creates more supply. This creates a positive output gap (at point b).
To learn more about the output gaps check our explanation about the Economic Cycle.
Aggregate supply is a measure of the total volume of goods and services produced in the economy over a given time.
The determinants of aggregate supply mainly affect the production side of the economy and include: costs of production, labour productivity, technical progress, and others.
When there is a change in the factors that affect the supply-side of the economy like production costs, labour productivity, technical progress, and others.
The two types of aggregate supply are:
To draw the aggregate supply curve you have to take into account other factors like the short or long run because those factors change the curves.
What is aggregate supply?
Aggregate supply (AS) is a measure of the total volume of goods and services produced in the economy over a given time period.
Name two types of aggregate supply.
Short-run and Long-run
What remains constant in the movement along the aggregate supply curve?
What changes in the shift of the aggregate supply curve?
Which is the vertical aggregate supply curve?
The long-run aggregate supply curve
Who suggested the other concept of LRAS?
When does macroeconomic equilibrium occur?
Macroeconomic equilibrium occurs when aggregate demand meets aggregate supply.
How can we determine the output gap?
The output gap is the difference between the actual output and the potential or trend output.
What are the types of the output gap?
What is a positive output gap?
A positive output gap occurs when the actual output is above the potential or trend output.
What is a negative output gap?
A negative output gap occurs when the actual output is below the potential or trend output.
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