Aggregate Supply - A-Level Economics
Aggregate Supply
What is Aggregate Supply?
Aggregate Supply is defined as the amount firms are willing to supply at any given price level.
There are two types of AS:
- Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are held constant.
Long run aggregate supply (LRAS) shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked to the production possibility frontier
LRAS: Keynesian vs. Monetarist
There are two views of aggregate supply: the Monetarist (classical) view and the Keynesian view.
Monetarist (classical)
This classical view believes that in the long run the economy will operate at full capacity (on their PPF) and there will be no unemployed resources-‐ the AS curve is vertical.
The view believes that surplus of any unemployed resources will lead to a fall in their price until the surplus disappears. For example, if there is unemployment in the market (excess supply of labour), they believe that the wage rate will fall until there is no excess.
The classical view therefore believes that in the long run the price mechanism will get rid of any excess resources in the economy.
Keynesian
The Keynesian view is the one that is used in AS economics. This view believes that the equilibrium level of output can occur at a point where the economy is below full capacity.
Keynesians believe that wages are ‘sticky downwards’-‐ they do not tend to fall much even if supply of labour is in excess (i.e. there is unemployment). They believe that if there is unemployment in the economy, trade unions and minimum wage regulations will prevent wages falling to remove this excess. Therefore, at the equilibrium level of output, there is still unemployment in the economy.
Insert Diagram in Revision Guide page 25
The graph above shows that the Keynesian AS curve has three main stages:
Stage A
At this stage there is spare capacity in the economy (e.g. unused capital, unemployment). The economy can increase output without any cost pressures by simply employing the unused resources. At this point, a shift in the AD curve to the right would lead to an increase in output without increasing the price.
Stage B
At this stage, as the economy is approaching full capacity, supply starts to become more inelastic. The economy is near full capacity, so the cost of resources (e.g. labour) might rise, and so an increase in output will lead to a rise in price.
Stage C
At this stage the economy is at full capacity-‐ the maximum level of output has been reached. All workers are employed, so if a firm wants to increase output it has to entice workers away from other jobs by offering higher wages. A shift in the AD curve to the right will lead to a rise in price and no increased output.
What are the factors influencing the amount firms are willing to supply at any givenprice level?
Factors Influencing the Position of the AS Curve
The greater the productive capacity of a firm, the more it will supply at any given price level. For example, a small computer shop will supply fewer computers than a large computer store at a given price level.
We can apply this to the whole economy-‐ the greater the productive capacity in the economy, the more supplied at any given price level and the greater the aggregate supply (the further the AS curve is to the right).
There are several factors which influence the amount firms are willing to supply at various prices:
Level of Investment
Investment in capital stock expands the productive capacity of the economy.
If investment is high, the productive capacity will increase and the efficiency of factor inputs will increase (leading to a fall in production cost). This will lead to a greater supply at any given price level-‐ AS is higher.
Therefore, the higher the investment in the economy, the greater the quantity supplied at a given price level.
Availability of Factors of Production
The more resources (factor inputs) there are in the economy, the greater the productive capacity, and hence the higher the aggregate supply.
The higher the quality of resources (factor inputs) in the economy, the greater the productive capacity, and hence the higher the aggregate supply.
Costs of Production
The higher the cost of production in the economy, the lower the aggregate supply (the further the AS curve is to the left).
If production costs are high, profits are reduced for firms so they supply less at any given price level-‐ AS is lower.
If production costs are low, there are increased profit margins for firms, so they supply more at any given price level-‐ AS is higher.
What factors might shift the Aggregate Supply curve?
- Changes in price level result in movement along the as curve-‐ they do not shift the curve.
- A fall in AS means the curve shifts to the left.
- A rise in AS means the curve shifts to the right.
Changing Costs of Raw Materials
A global rise in the price of raw materials will lead to a rise in production costs, and hence a fall in LRAS.
The term ‘global’ means that prices increase around the world, not just due to a change in exchange rate in the UK.
Exchange Rates
A rise in the exchange rate will reduce the price of imported raw materials, reducing production costs, and hence increasing LRAS.
For example, if the pound rose in value relative to the euro, imports will be cheaper and hence imported raw materials from the Euro-‐zone will be cheaper for firms, so production costs fall.
Change in International Trade
As foreign countries open up to more trade, competition drives down prices and inefficient domestic firms give way to overseas firms. Imported raw materials therefore become cheaper for UK firms, production costs fall, and LRAS falls
Technological Advances
Technological advances increase the productive capacity of firms in the economy and also decrease production costs, leading to a rise in LRAS.
For example, technological advancements mean that book stores can now sell eBooks. The book stores save money in terms of printing, shipping and handling costs-‐ so production costs fall. Also, the productive capacity of the stores increase-‐ they can now supply unlimited numbers of books.
Relative Productivity Changes
Productivity is the output produced per unit of input.
If productivity of an economy increases relative to other economies, production costs for firms will decrease and the productive capacity of firms will rise. This will lead to a rise in LRAS.
Education and Skills Changes
Increased investment in education and skill will mean more people are able and willing to work in the economy-‐ the supply of labour increases. Productivity of workers will also increase. Therefore, there is an increase in quality and quantity of labour, leading to an increase in LRAS.
However, the effect depends on what the money is invested in. Investment in primary schools will have a smaller effect on the workforce than investment in universities.
Regulation Changes
Income Tax Level
A rise in income tax will reduce the opportunity cost of being inactive. More workers will leave work and become inactive, so the productive capacity of the economy decreases-‐ LRAS decreases.
Increase in Health Spending
An increase in health spending will reduce sick days and will mean that workers are active for longer-‐ often beyond the traditional retirement ages. This increases the supply of labour. Better health of the workforce will also increase productivity of workers-‐ quality of labour increases. Therefore the productive capacity increases and LRAS increases.
However, the effect on the workforce will be minimal if a large proportion of the money is spent on increasing the wages of doctors as opposed to improving the quality of healthcare. Also, the majority of healthcare spending goes on the elderly or youth, neither of whom are economically active.
Interest Rates
A reduction in the bank will lead to increased investment in capital stock, leading to an increase in productive capacity and a fall in production cost-‐ LRAS will increase.
| Event | Aggregate Demand | Aggregate Supply |
|---|---|---|
| Fall in the Exchange Rate | Increases o Imports increase o Exports decrease | Decreases o Imported raw materials are cheaper |
| Increase in income tax rate | Decreases o Consumer have less disposable income, so consumption decreases o Tax is a leakage from circular flow, so there is less consumption and investment | Decreases o Increase in inactivity, so supply of labour falls |
| More business investment | Increases o Investment is a component of AD o More investment = more jobs = more consumption | Increases o Increase in productive capacity and fall in production costs |
| Increase in NHS spending | Increases o Government spending is component of AD o Government spending 🡪 more jobs 🡪 more income 🡪 more consumption | Increases o Fewer sick days o Workers are active for longer |
| Recession in Euro-‐Zone | Decreases o Less consumption abroad, so exports fall | Increase o Increased immigration into the UK = greater supply of labour = increase in productive capacity |
| Rise in Oil Prices | Decreases o Oil is an inelastic good, so continues to be purchased in same quantity. Oil is imported into the UK, so value of imports rises, so AD falls. o Consumers have less money to spend because they have to pay more for oil, so consumption decreases | Decreases o Oil is an important raw material, so there will be a rise in production costs. |
| Crash in World Stock Markets | Decreases o Decreased consumption (negative wealth effect) Fall in exports o Arguably, there is a fall in imports but the two factors above are more dominant. | Minimal effect |
| Reduction in Bank Rate | Increases o Less saving= more investment and consumption | Increases o Increased investment = increase in productive capacity & reduced production costs |
| Increase in Unemployment | Decreases o Fall in consumption | Decreases o Some workers might become inactive and some might go into training. So supply of labour falls, PPF shifts inwards and AS falls |
| Migration/ Increase in Birth Rate | Increases o Higher population = more consumption | Increases o Greater supply of labour = increase in productive capacity |
Aggregate Supply refers to the total amount of goods and services that all firms in an economy are willing and able to produce and sell at a given price level.
The factors that affect Aggregate Supply include changes in production costs, changes in the level of technology, changes in the availability of resources, and changes in the overall level of business confidence.
Short-Run Aggregate Supply (SRAS) refers to the total amount of goods and services that all firms in an economy are willing and able to produce and sell in the short-run, at a given price level. Long-Run Aggregate Supply (LRAS) refers to the total amount of goods and services that all firms in an economy are willing and able to produce and sell in the long-run, at a given price level.
The shape of the Short-Run Aggregate Supply curve is upward sloping, which means that as the price level increases, the quantity of goods and services that firms are willing and able to produce and sell in the short-run also increases.
The shape of the Long-Run Aggregate Supply curve is vertical, which means that the quantity of goods and services that firms are willing and able to produce and sell in the long-run is not affected by changes in the price level.
An increase in production costs, such as an increase in wages or raw material costs, will lead to a decrease in Aggregate Supply, as firms will be less willing and able to produce and sell goods and services at the same price level.
An increase in technology will lead to an increase in Aggregate Supply, as firms will be able to produce and sell more goods and services at the same price level.
A decrease in the availability of resources, such as a decrease in the supply of oil, will lead to a decrease in Aggregate Supply, as firms will be less able to produce and sell goods and services at the same price level.
An increase in business confidence, such as an expectation of future economic growth, will lead to an increase in Aggregate Supply, as firms will be more willing and able to invest in production and expand their operations.
Aggregate Supply is important for the economy because it determines the total amount of goods and services that are available for consumers to purchase, and it influences the overall level of prices and inflation in the economy.
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