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!
What is aggregate supply?
Aggregate supply, also known as AS, represents the overall amount of goods and services that businesses are willing and able to produce and sell in the economy. It depicts the relationship between the price level in the economy and the total quantity of output, or real GDP, that firms are willing to supply. Essentially, it shows how much the economy can produce at different price levels.
Aggregate supply refers to the total quantity of goods and services that all firms in an economy are willing and able to produce and sell at different price levels, holding all other factors constant.
Let's imagine an economy where the aggregate supply is determined by the availability of resources, technology, and the willingness of firms to produce. Suppose there is a sudden technological breakthrough, allowing firms to produce goods more efficiently. This technological advancement increases the productivity of businesses, leading to a shift in the aggregate supply curve to the right.
As a result, firms can produce and sell more goods and services at every price level, increasing overall output and potential economic growth. On the other hand, if there is a shortage of resources or an increase in production costs, the aggregate supply curve might shift to the left, limiting the economy's ability to produce and potentially leading to lower output levels.
Aggregate supply factors with examples
Aggregate supply, which represents the total quantity of goods and services an economy produces, is influenced by various factors called determinants of aggregate supply. Factors affecting aggregate supply are categorised in the following groups: changes in commodity prices, changes in nominal wages, changes in productivity, changes in inflation expectations, and changes in resource availability.
Changes in commodity prices
Fluctuations in commodity prices, including raw materials and energy, have a significant impact on aggregate supply. When commodity prices rise, businesses experience higher production costs, potentially decreasing aggregate supply. Conversely, declining commodity prices can lower production costs, enabling businesses to expand their supply.
For example, an increase in oil prices can raise transportation costs, affecting industries reliant on fuel and potentially constraining their aggregate supply.
Changes in nominal wages
Nominal wages, the wages received by workers in current dollars, play a vital role in determining aggregate supply. When nominal wages increase, businesses face higher labor costs, which can reduce their profitability and result in a decrease in aggregate supply. Conversely, stable or decreasing nominal wages can help control costs and potentially contribute to an increase in aggregate supply. Government policies, such as minimum wage regulations, can directly influence nominal wages and impact aggregate supply.
For instance, a mandated increase in the minimum wage may raise labor costs for businesses and lead to a reduction in their aggregate supply.
Changes in productivity
Productivity growth, driven by factors like technological advancements and efficiency improvements, significantly impacts aggregate supply. Higher productivity allows businesses to produce more output with the same amount of resources, leading to an expansion in aggregate supply. Technological innovations, automation, and streamlined processes can enhance productivity, enabling businesses to increase their supply of goods and services. Conversely, a decline in productivity growth can limit an economy's production capacity and result in a decrease in aggregate supply.
For example, the development and widespread adoption of 3D printing technology have significantly increased productivity in various industries, allowing for on-demand production, customization, and reduced production costs
Changes in inflation expectations
Inflation expectations, which reflect anticipated future inflation rates, can influence aggregate supply. High inflation expectations can lead to changes in behavior, with workers demanding higher wages to keep pace with rising prices. This increase in labor costs can raise business production costs and potentially reduce aggregate supply. Conversely, if inflation expectations are low or stable, businesses can make more confident long-term plans, potentially supporting an expansion in aggregate supply.
Changes in resource availability
The availability of resources, such as natural resources and capital, is a crucial determinant of aggregate supply. An increase in resource availability can expand an economy's production potential and lead to an increase in aggregate supply. Conversely, a decline in resource availability can limit production capacity, potentially resulting in a decrease in aggregate supply.
For example, the depletion of fish stocks due to overfishing can constrain the aggregate supply of the fishing industry and related sectors.
Understanding the interplay between changes in commodity prices, nominal wages, productivity, inflation expectations, and resource availability provides valuable insights into the dynamics of aggregate supply. Various external forces, including government policies, technological advancements, and the availability of resources influence these factors. By comprehending these influences, policymakers can make informed decisions to support economic growth and stability.
Short-run aggregate supply (SRAS) curve
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.
To explore this topic in more detail check out our explanation Short Run Aggregate Supply
Movement along the short-run aggregate supply (SRAS) curve
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.
Fig. 1 - Movement Along SRAS 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.
Shifts of the short-run aggregate supply (SRAS) curve
As we explained before, the output price level is variable when talking about movement along the curve while the other factors stay constant. However, when there is a change in other factors like 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
Fig. 2 - Shifts in SRAS
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 (SRAS) | Price | Other factors (production costs, labour productivity, technology, etc.) |
| Movement | Changes | Constant |
| Shift | Constant | Change |
Table 1. Comparison between the movements and shifts in short-run aggregate supply.
Long-run aggregate supply (LRAS) curve
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.
To explore this topic in more detail check out our explanation Long Run Aggregate Supply
Position of the long-run aggregate supply (LRAS) curve
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.
Fig. 3 - LRAS Curve, StudySmarter Original
Shifts of the long-run aggregate supply (LRAS) curve
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.
- Enterprise.
- 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 shift 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, the LRAS can shift to the left if the other factors deteriorate.
Fig 4 - Shift in LRAS Curve
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.
Keynesian long-run aggregate supply (LRAS) curve
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 a price increase. 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).
Fig 5. - Keynesian LRAS Curve
Aggregate supply and aggregate demand interaction
The interaction between aggregate demand and aggregate supply curves is very important in macroeconomics.
Macroeconomics equilibrium
Macroeconomic equilibrium occurs when the aggregate demand curve and aggregate supply curve meet. The change in any of the curves results in a change in equilibrium.
Increase in aggregate demand (AD) and output
The increase in aggregate demand (AD) affects the aggregate supply curve differently for short-run and long-run aggregate supply as the SRAS is upward sloping and LRAS is vertical.
In the short run, as the aggregate demand increases, the aggregate supply increases too at the higher price. The increased supply results in the movement along the SRAS curve to the right.
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.
Limitations of the multiplier effect
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 shift in the aggregate supply curve and its effects
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.
Output gaps, aggregate demand and aggregate supply
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).
Fig. 6 - Output Gaps
To learn more about the output gaps check our explanation about the Economic Cycle.
Aggregate Supply - Key takeaways
- The aggregate supply (AS) measures the total volume of goods and services produced in the economy over a given time.
- The aggregate supply behaves differently over the short run and long run and its curves changes accordingly.
- The factors that affect the aggregate supply curves are price, time, employer wages, technological changes, inflation and deflation, government policies, and availability of resources.
- Macroequilibrium is when the aggregate demand meets the aggregate supply.
- The output gap occurs when the actual output is different from the potential output.
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