7.2 Aggregate Supply (AS) Curve

The Aggregate Supply (AS) curve is a crucial component in understanding how an economy's output responds to price level changes. It shows the relationship between the total quantity of goods and services produced and the overall price level, with distinct short-run and long-run versions.

This topic explores the factors that shape the AS curve, including input prices, productivity, and government policies. Understanding these elements is key to grasping how supply-side shocks can impact economic equilibrium, inflation, and growth in both the short and long term.

Short-run vs Long-run Aggregate Supply

Short-run Aggregate Supply (SRAS) Curve

• Shows the relationship between the price level and the quantity of real GDP supplied in the short run, holding other factors constant
• Upward sloping due to sticky wages and prices
  • As the price level increases, firms can sell their output at higher prices, while input costs remain relatively constant, leading to higher profits and an incentive to increase output (oil prices, rent)
  • Workers resist nominal wage cuts, so wages take time to adjust downward when the price level falls (union contracts, minimum wage laws)

Long-run Aggregate Supply (LRAS) Curve

• Shows the relationship between the price level and the quantity of real GDP supplied in the long run, when all prices and wages are fully flexible
• Vertical line at the full-employment level of output, also known as potential GDP
  • In the long run, the economy will always return to its potential GDP level, regardless of the price level (natural rate of unemployment, full capacity utilization)
  • Determined by factors such as technology, capital stock, and the size of the labor force, which are independent of the price level (productivity growth, immigration)

Factors Influencing AS Curve Shape

Elasticity of SRAS Curve

• SRAS curve becomes steeper (less elastic) when there is less spare capacity in the economy
  • Firms find it more difficult to increase output in response to higher prices (limited factory space, shortage of skilled workers)
  • Upward pressure on input costs as firms compete for scarce resources (higher wages, rising raw material prices)
• SRAS curve becomes flatter (more elastic) when there is more spare capacity in the economy
  • Firms can easily increase output in response to higher prices without putting upward pressure on input costs (idle machinery, unemployed workers)
  • Input costs remain relatively stable as firms can access underutilized resources (abundant raw materials, available labor pool)

Vertical LRAS Curve

• In the long run, the quantity of real GDP supplied is determined by factors independent of the price level
  • Technology and productivity improvements allow firms to produce more output with the same amount of inputs (automation, efficient production techniques)
  • Capital stock increases through investment, enabling higher levels of output (new factories, upgraded equipment)
  • Size and quality of the labor force grow due to population growth, immigration, and education (skilled workers, increased labor force participation)

Determinants of AS Curve Shifts

Input Price Changes

• Increase in input prices shifts the SRAS curve to the left (decrease in AS)
  • Higher wages raise the cost of labor, reducing profitability and output (minimum wage increases, collective bargaining agreements)
  • Rising raw material prices squeeze profit margins, forcing firms to cut back on production (oil price shocks, tariffs on imported inputs)
• Decrease in input prices shifts the SRAS curve to the right (increase in AS)
  • Lower wages reduce labor costs, enabling firms to increase output and profitability (reduced union power, increased labor market competition)
  • Falling raw material prices improve profit margins, encouraging firms to expand production (technological advancements in resource extraction, subsidies for key inputs)

Productivity and Technology Changes

• Technological advancements that improve productivity shift both SRAS and LRAS curves to the right
  • Firms can produce more output with the same amount of inputs, lowering costs and increasing AS (automation, efficient production techniques)
  • Productivity growth allows the economy to produce more goods and services without generating inflationary pressures (computers, internet)

Labor Force Changes

• Increase in the size and quality of the labor force shifts the LRAS curve to the right
  • Population growth and immigration expand the available pool of workers, enabling higher levels of output (baby boom, relaxed immigration policies)
  • Improvements in education and skills development enhance the productivity of the labor force (college education, vocational training programs)

Government Policies

• Regulations that increase the cost of production shift the SRAS curve to the left
  • Environmental regulations raise compliance costs, reducing output and profitability (emissions standards, renewable energy mandates)
  • Occupational safety and health regulations impose additional costs on firms, constraining their ability to increase production (workplace safety rules, mandatory benefits)
• Subsidies that lower the cost of production shift the SRAS curve to the right
  • Government support for specific industries reduces input costs, encouraging higher levels of output (agricultural subsidies, research and development grants)
  • Tax incentives for investment and hiring stimulate production by lowering the cost of capital and labor (accelerated depreciation, payroll tax cuts)

Impact of AS Changes on Equilibrium

Short-run Equilibrium Effects

• Rightward shift in SRAS curve (increase in AS) leads to lower price level and higher real GDP
  • Decrease in input prices or increase in productivity moves the economy to a new equilibrium point (falling oil prices, technological breakthroughs)
  • Helps close recessionary gaps and stimulate economic growth (increased output, reduced unemployment)
• Leftward shift in SRAS curve (decrease in AS) leads to higher price level and lower real GDP
  • Increase in input prices or decrease in productivity moves the economy to a new equilibrium point (wage push inflation, natural disasters)
  • Can exacerbate inflationary pressures and slow economic growth (rising prices, reduced output)

Long-run Equilibrium Effects

• Rightward shift in LRAS curve (increase in potential GDP) leads to higher level of real GDP without affecting the price level
  • Technological advancements or increase in the size and quality of the labor force expand the economy's production possibilities (productivity growth, immigration)
  • Enables sustainable economic growth without generating inflationary pressures (increased living standards, stable prices)

Interaction with Economic Conditions

• Impact of AS changes depends on the initial state of the economy
  • If operating below potential GDP, an increase in AS can help close the recessionary gap and move towards full employment (fiscal stimulus, accommodative monetary policy)
  • If operating at or above potential GDP, an increase in AS can help reduce inflationary pressures (supply-side reforms, productivity-enhancing investments)
• AS changes can amplify or mitigate the effects of shifts in aggregate demand
  • Rightward shift in AS can offset the inflationary impact of an increase in AD (technological progress, falling input prices)
  • Leftward shift in AS can exacerbate the recessionary effects of a decrease in AD (oil price shocks, natural disasters)