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IB DP Economics Study Notes

3.2.2 Aggregate Supply

Aggregate supply captures the relationship between the overall price level and the total output of goods and services in an economy. It's a foundational concept in macroeconomics, bridging the gap between individual production decisions and the overarching price levels.

Short run vs Long run

To fully understand aggregate supply, it's pivotal to differentiate between the short run and the long run.

Short Run Aggregate Supply (SRAS)

The short run in economics isn't defined by a specific timeframe, but rather by the flexibility (or lack thereof) of certain factors of production. Here, capital and technology are held constant, but other inputs can be varied.

  • Positive Relationship: In the short run, there's a direct relationship between the aggregate price level and the quantity of goods and services supplied. As prices rise, output tends to increase since it becomes more lucrative for producers.
  • Sticky Wages: Wages often resist immediate change, even when prices move rapidly. If prices jump, and wages lag behind, it becomes temporarily more profitable for firms to produce, hence boosting the output.
  • Costs of Production: If there's a sudden increase in the costs of raw materials or other inputs, firms might reduce production, leading to a leftward shift of the SRAS curve. Understanding the non-price determinants of supply is crucial in this context.
  • Infrastructural Constraints: All firms have production limits. Once these are reached, no matter how much prices rise, the output can't increase in the short run. It's important for students to understand this constraint when studying the short run dynamics.

Long Run Aggregate Supply (LRAS)

In the long run, all factors of production become flexible. This means firms can adjust their capital stock, adopt new technologies, hire or fire workers, and source different raw materials.

  • Potential Output: Represents the maximum sustainable amount the economy can produce, given its resources and technology. It's an important concept as it indicates the full capacity of an economy.
  • No Relationship with Price Level: In the long run, price changes don't affect the quantity supplied. This is because all the variable costs, including wages and input prices, adjust accordingly over time. This self-adjustment mechanism ensures that production is based solely on an economy's capacity and not on price incentives. The interplay between aggregate demand and aggregate supply further illustrates this dynamic.

Shift Factors

The aggregate supply curve, both in the short and long run, can shift due to various reasons:

Short Run Shift Factors

  • Commodity Prices: If there's a sudden spike in oil prices, this can increase costs for many firms, leading to a decrease in SRAS.
  • Supply Shocks: These are unexpected events – for instance, a natural disaster might disrupt production lines, causing the SRAS curve to shift to the left. Conversely, a boon in production technology might lead to a rightward shift.
  • Government Action: Policies such as subsidies or taxes can affect production costs. For instance, a new tax on production will increase costs, leading to a decrease in SRAS. The impact of government policies on fiscal policy limitations and monetary policy limitations should also be considered.
A graph of shifts in short run aggregate supply curve

A graph illustrating the shifts in short run aggregate supply curve.

Image courtesy of albert

Long Run Shift Factors

  • Technological Advancements: Over time, as firms adopt new technologies, they can produce more with the same amount of resources. This boosts potential output and shifts LRAS to the right.
  • Education and Training: A well-trained workforce can enhance production efficiency. When workers are better educated or undergo beneficial training, they can produce more or higher quality goods, increasing potential output.
  • Demographic Changes: An increasing population or a rise in the working-age population can lead to a rightward shift in LRAS as there are more workers available for production.
  • Government Policies: Investment in infrastructure, R&D subsidies, and favourable business policies can all increase potential output. It's vital to understand how negative externalities of production can shift the LRAS curve by affecting the productive capacity of an economy.
A graph of shift in long run aggregate supply curve

A graph illustrating the shift in long run aggregate supply curve.

Image courtesy of albert

Graphical Representation

Representing aggregate supply graphically provides a visual tool to understand the relationship between price levels and output.

Short Run

  • The SRAS curve is upward sloping, showing the direct relationship between the price level and output in the short run.

Long Run

  • The LRAS curve is a vertical line. It remains stationary at the potential output of the economy, demonstrating that in the long run, production is unaffected by price changes.
Graphs of short run aggregate supply and long run aggregate supply

Graphs illustrating short run aggregate supply and long run aggregate supply.

Image courtesy of ezyeducation

Placing both SRAS and LRAS on the same graph provides a snapshot of the economy's current state. Their intersection point denotes the current equilibrium. Any shift in either curve will result in a change in this equilibrium, leading to different real output and price levels.

When studying aggregate supply, always consider the broader context: what happens in one sector can influence another, and short-term changes might have long-term consequences. Understanding these dynamics is key for anyone diving deep into macroeconomics.

FAQ

A leftward shift in the Short Run Aggregate Supply (SRAS) curve signifies a decrease in the quantity of goods and services supplied at each price level. Such a shift can arise due to various reasons. For example, if there's a sudden increase in the cost of raw materials, production costs for businesses would rise, making them less inclined to produce as much as before at the same price level. Similarly, natural disasters, strikes, or geopolitical events can disrupt production processes or the supply of key inputs, leading to decreased supply and a leftward shift in the SRAS curve.

Government policies can have a substantial effect on the position of the LRAS curve. For instance, policies that promote research and development can lead to technological advancements, allowing firms to increase their output capacity, thus shifting the LRAS to the right. Similarly, investments in education and training can enhance human capital, leading to increased productivity and a rightward shift of the LRAS. On the contrary, policies that discourage investments, whether through stringent regulations or high taxes, can deter firms from expanding or upgrading, potentially causing a leftward shift in the LRAS as potential output decreases.

The Long Run Aggregate Supply (LRAS) curve is an invaluable tool in understanding an economy's growth potential. It represents the maximum amount of goods and services an economy can produce when it is fully utilising all its resources, effectively indicating its potential output. By analysing where the LRAS stands and its potential shifts, policymakers and economists can discern the economy's capacity for growth. A rightward shift in the LRAS means the economy has increased its potential output, which is indicative of economic growth. Conversely, a stagnant or leftward-moving LRAS might suggest issues hindering growth, necessitating interventions to enhance productive capacity.

The Long Run Aggregate Supply (LRAS) curve is vertical because it represents an economy's potential output or productive capacity, which remains unchanged by variations in the price level in the long run. Over time, as prices rise, costs also rise in tandem. This means that even if firms could produce more in response to higher prices initially, these benefits get nullified as costs catch up. Therefore, in the long run, production is determined solely by the factors of production available—such as labour, capital, and technology—rather than the price level, resulting in the vertical depiction of LRAS.

The Short Run Aggregate Supply (SRAS) curve slopes upwards primarily due to the inflexibility of certain factors in the short term. In the short run, when the price level rises, many production costs, especially wages, do not immediately adjust upwards. This time lag means that businesses can enjoy temporarily higher profit margins as they receive higher prices for their goods while not yet paying increased costs. This incentive encourages them to produce and supply more. Thus, as the price level rises, the quantity of goods and services supplied in the short run also increases, leading to the upward slope of the SRAS curve.

Practice Questions

Explain the difference between Short Run Aggregate Supply (SRAS) and Long Run Aggregate Supply (LRAS) in terms of their relationship with the overall price level.

Short Run Aggregate Supply (SRAS) demonstrates a direct relationship with the overall price level. In the short run, when the price level increases, producers are incentivised to supply more, assuming wages and other costs lag behind this price rise. This positive correlation gives the SRAS curve its upward slope. On the other hand, Long Run Aggregate Supply (LRAS) showcases no relationship with price level. This is because, over time, all costs adjust to price changes, making production depend solely on an economy's capacity and resources. Thus, the LRAS is represented as a vertical line, indicating the economy's potential output, unaffected by price variations.

Identify and discuss two factors that can lead to a shift in the Long Run Aggregate Supply (LRAS).

Technological advancements are a pivotal factor influencing LRAS. As firms adopt new and improved technologies, they can produce more efficiently and effectively, increasing their output with the same resources. This boost in potential output results in a rightward shift in LRAS. Furthermore, education and training play a significant role in determining LRAS. A workforce that has better education or has undergone advanced training can produce goods of higher quality and in greater quantities. Such improvements in human capital enhance production efficiency, leading to an increase in potential output and causing the LRAS to shift to the right.

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