2.3 Aggregate Supply – Edexcel Economics A notes

Contents

What is aggregate supply?

Aggregate supply (AS) is the total supply of goods and services in the economy for a given time period.

Broadly, the level of aggregate supply depends on:

• The price level – a (weighted) measure of average prices in the whole economy.
  • A change in price level leads to a movement along the AS curve. 
  • AS can be upward-sloping, vertical or flat, depending on your assumptions (see below on SRAS and LRAS).
• Other factors, such as productivity and business costs.
  • A change in another factor, that affects AS, leads to a shift in AS.

There are also different types of aggregate supply curves, depending on the time frame:

• Short run – at least one factor of production is fixed (e.g. capital).
• Long run – all factors of production are variable.

Short-run aggregate supply (SRAS)

Why is SRAS upward sloping?

SRAS is upward sloping. 

This means as the price level rises, SRAS increases.

• The vertical axis of our diagram shows the price level.
• The horizontal axis shows real GDP (you can also write real national output or RNO). This is the total value of goods and services produced within an economy in a given time period.

Why is SRAS upward sloping?

• As the price level rises, there is a greater incentive for firms to increase production, owing to the higher profit firms can make on additional units produced.
  • This is the same argument as to why the supply curve in microeconomics is upward sloping.

What causes the SRAS to shift?

Which factors shift the SRAS to the right? In short, any factors that influence business costs:

• Lower business costs, for example lower costs of raw materials, energy or labour. 
  • Changes in costs could occur for several reasons. For instance, a lower minimum wage may reduce labour costs for firms.
  • Similarly, an increase in labour supply could lower equilibrium wages, leading to lower business costs.
  • Also if productivity rises, the SRAS shifts right.
    • Productivity is the amount produced per unit of input.
    • If workers are more productive for example, firms can produce more with the same number of workers. This increases SRAS.
    • This can also be viewed as a fall in the cost per unit produced – firms are paying the same wages but to produce a greater amount.
• Appreciation of currency (currency rises in value vs others) makes imports cheaper. So firms that import inputs see lower costs.
• Fall in value added tax (VAT), or a fall in any other tax like tariffs.
  • Tariffs are taxes on imports. If firms import raw materials and tariff rates fall, it will be cheaper to import raw materials as inputs. This reduces business costs and shifts SRAS right.
  • Other taxes affect firms, such as corporation tax (a tax on profits). A cut in corporation tax rates would reduce firms’ tax bills, reducing firms’ costs.

Note that the opposite changes, for instance a rise in costs of raw materials, shift the SRAS to the left.

How to evaluate shifts in the SRAS

To evaluate shifts in SRAS, consider:

• The importance of the input (whose cost is changing) relative to total business costs.
  • Suppose energy prices rise. This will not increase costs significantly for firms that rely on labour instead. Examples of labour-intensive services could include hairdressing or cleaning.
  • Moreover, energy dependent firms may be able to reduce their dependence on energy over time. This could involve energy efficiency improvements, switching to other factors of production such as labour, or producing their own energy on site rather than buying energy from an energy company.
• For changes in the value of the currency, the extent to which firms trade across borders versus supplying domestically.
  • For firms who do not rely on imported inputs, their costs are unaffected by currency fluctuations.
  • Also firms may “hedge”. This involves holding multiple currencies at once, to protect against the risks of currency fluctuations. This reduces the impact of currency fluctuations on firms’ costs.
• As for tax changes, consider whether all firms are affected by the tax changes:
  • Corporation tax changes only apply to firms making profits. If firms are not making profits (survival) or reinvest all their revenues so that their profits are low, then corporation tax changes may have less of an impact on SRAS.

Long-run aggregate supply (LRAS)

There are two types of LRAS: Classical and Keynesian.

Classical LRAS

• The Classical LRAS is perfectly inelastic at “full employment” level of output.
  • This means the LRAS is drawn vertically.
• Under this assumption, the economy will always return to the full employment level of output in the long run. 

Keynesian LRAS

• The Keynesian LRAS is perfectly elastic at low levels of real GDP, where there is high spare capacity.
  • When there is high spare capacity, this means there can be high unemployment and underutilised capital.
  • In this case, firms can increase their production levels without paying workers higher wages, as there are many other unemployed looking for work. So firms do not need to raise prices.
  • So as real GDP increases, the price level does not rise.
• However, just like the Classical LRAS, the Keynesian LRAS is also perfectly inelastic, but only at the full employment level of real GDP.
  • For one firm to increase production, it has to pay higher wages to attract workers from other sectors.
  • So overall real GDP is not change, but the price level is rising.

Which factors shift the LRAS?

Factors that shift LRAS:

• Technology and productivity advances
  • For example, the introduction of computers or more recently, firms using artificial intelligence (AI) including ChatGPT.
  • This allows firms to make more efficient use of their capital and labour, boosting potential output with the same inputs.
  • However this depends on how widely technological innovations are adopted. Limited adoption may mean productivity does not rise as much.
• Improving skills through education or training.
  • Education or training increases the level of human capital (workers’ skills, knowledge or other qualities), boosting productivity.
  • However if people do not attend the education or training, workers’ skills may not improve. So productivity may not rise.
• Income tax and corporation tax cuts
  • Income tax cuts incentivise workers to work more.
  • Corporation tax cuts encourage businesses to grow. Similarly it may increase business investment into new capital, boosting productivity.
  • This increases productive potential.
• Deregulation
  • Removing regulation reduces costs of compliance with regulation for businesses.
  • This increases profits and investment in capital.
  • This also removes barriers to entry, encouraging more firm entry and increasing productive capacity.
• Migration or demographic changes
  • This could include a higher birth rate or an increase in the rate of immigration.
  • This may increase labour supply, boosting productive capacity.
  • However this depends on the proportion of the new population who are part of the labour force and their skill level. For instance, an increase in the birth rate may not increase labour supply immediately, as it may take decades before those recently born enter the labour force.
• Competition policy
  • For example breaking up large firms or preventing mergers.
  • This reduces monopoly power. So there are more firms enter the market.
  • More firms in the market means there is greater competition. This will force firms to become more efficient, lowering their costs and producing more with the same inputs. This shifts LRAS to the right.

For more on supply-side policies, see the article here.

The diagram below shows a shift right in the LRAS:

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