10.2 Aggregate Supply: Short-run and Long-run

Aggregate supply is a crucial concept in understanding how economies function. It shows the total output firms can produce at different price levels, with short-run and long-run distinctions reflecting how quickly businesses can adjust their production.

The short-run aggregate supply curve is upward sloping, while the long-run curve is vertical. This difference stems from wage and price flexibility, affecting how output responds to changes in aggregate demand and other economic factors.

Short-run vs Long-run Aggregate Supply

Defining SRAS and LRAS

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• Short-run aggregate supply (SRAS) represents total output firms produce at various price levels within one year
  • Upward sloping curve indicates higher production as price level increases
• Long-run aggregate supply (LRAS) shows total output at full employment with flexible prices and wages
  • Vertical curve represents potential output independent of price level
• SRAS and LRAS differ in input price flexibility, particularly wages
  • Wages sticky in short run but fully adjustable in long run
• Changes in aggregate demand affect output and employment along SRAS curve
• Economy tends to return to natural rate of output in long run

Short-run vs Long-run Economic Adjustments

• SRAS allows for temporary deviations from full employment output
  • Firms can adjust production quickly in response to price changes
  • Examples: Increasing overtime hours, utilizing excess capacity
• LRAS represents economy's maximum sustainable output
  • All prices and wages fully adjust in long run
  • Examples: New factories built, workers retrained for different industries
• Short-run fluctuations occur around long-run trend
  • Business cycles create temporary booms and recessions
  • Economy gravitates towards full employment in long run (natural rate of unemployment)

Determinants of Aggregate Supply

Resource and Technology Factors

• Resource availability impacts both SRAS and LRAS
  • Changes in quantity and quality of labor, capital, land, entrepreneurship
  • Examples: Discovery of new oil reserves, improved education systems
• Technological advancements influence SRAS and LRAS positively
  • Improvements in production processes and efficiency
  • Examples: Automation in manufacturing, artificial intelligence in services
• Input prices primarily affect SRAS
  • Fluctuations in costs of raw materials, wages, other production inputs
  • Examples: Oil price shocks, minimum wage increases

Economic and Policy Factors

• Expectations about future economic conditions impact SRAS
  • Anticipated changes affect current production decisions
  • Examples: Expected inflation leading to increased current production
• Government policies influence both SRAS and LRAS
  • Taxes, regulations, subsidies alter production costs and incentives
  • Examples: Corporate tax cuts, environmental regulations
• Institutional factors affect LRAS by influencing long-term productivity
  • Changes in property rights, legal systems, economic institutions
  • Examples: Improved contract enforcement, streamlined business registration

External and Environmental Factors

• Natural disasters and weather conditions typically impact SRAS
  • Temporary disruptions to production
  • Examples: Hurricanes damaging factories, droughts affecting agriculture
• Long-term climate change can affect both SRAS and LRAS
  • Gradual shifts in resource availability and production patterns
  • Examples: Rising sea levels affecting coastal infrastructure, changing agricultural zones

Aggregate Supply and Production Possibilities

Relationship Between AS and PPF

• Production possibilities frontier (PPF) shows maximum output combinations
  • Represents economy's productive capacity given resources and technology
• LRAS curve directly relates to PPF
  • Represents potential output at full employment and capacity
• LRAS intersection with x-axis corresponds to maximum sustainable PPF output
  • Reflects economy's overall productive capacity
• PPF shifts mirror LRAS curve shifts
  • Changes in resources, technology, efficiency affect both
• SRAS represents short-run output, may deviate from PPF
  • Temporary factors like price stickiness cause inefficiencies

Economic Efficiency and Resource Utilization

• Economy operates at points on PPF when at full employment
  • Corresponds to points along vertical LRAS curve
• Short-run fluctuations may lead to points inside PPF
  • Represents underutilization of resources or inefficiencies
• Movement along SRAS curve reflects changes in resource utilization
  • Economy can operate below or above full employment in short run
• Long-run growth expands both PPF and LRAS
  • Outward shifts represent increased productive capacity over time

Shifts in Aggregate Supply Curves

Positive Supply Shocks

• Increased resource availability shifts SRAS and LRAS right
  • Expands economy's productive capacity
  • Examples: Population growth, discovery of natural resources
• Technological improvements shift SRAS and LRAS right
  • Enhance productivity and efficiency
  • Examples: Development of new manufacturing processes, improved logistics systems
• Decreased input prices shift SRAS right
  • Lower production costs in short run
  • Examples: Falling oil prices, decreased raw material costs

Negative Supply Shocks

• Resource depletion or degradation shifts SRAS and LRAS left
  • Reduces economy's productive capacity
  • Examples: Overfishing, soil erosion
• Increased input prices shift SRAS left
  • Higher production costs in short run
  • Examples: Rising energy prices, increased labor costs
• Natural disasters typically shift SRAS left
  • Temporary disruptions to production
  • Examples: Earthquakes damaging infrastructure, floods destroying crops

Policy and Institutional Changes

• Positive government policies shift SRAS and LRAS right
  • Reduce costs or increase efficiency
  • Examples: Lower corporate tax rates, reduced regulatory burden
• Institutional improvements primarily shift LRAS right
  • Enhance long-term productivity and efficiency
  • Examples: Stronger property rights, improved education systems
• Negative policy changes shift SRAS and LRAS left
  • Increase costs or reduce efficiency
  • Examples: Higher taxes, stricter environmental regulations