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2.2.6 Determinants of long-run aggregate supply
‘The long run is a misleading guide to current affairs. In the
long run we are all dead. Economists set themselves too easy,
too useless a task if in tempestuous seasons they can only tell
us that when the storm is past the ocean is flat again.’
John Maynard Keynes
The Tract on Monetary Reform, 1923
AS: 3.2.2 H OW THE MACROECONOMY
WORKS
2.2.6 D ETERMINANTS
OF LONG - RUN
AGGREGATE SUPPLY

The fundamental determinants of long-run AS
such as technology, productivity, attitudes,
enterprise, factor mobility, and economic
incentives

The position of the vertical long-run AS curve
represents the normal capacity level of output of
the economy

It is assumed that the long-run AS curve is vertical
T HE D IFFERENCE B ETWEEN S HORT
AND L ONG -R UN
Recap.

In the short-run, all factors of production are fixed,
with the exception of labour which can be hired to
cover increases in aggregate demand

In the long-run, all factors of production are
variable and can be increased over time

In effect, long-run aggregate supply represents the
maximum possible output an economy can produce
as determined by its available land, labour, capital
and entrepreneurial resources
T HE L ONG -R UN A GGREGATE S UPPLY C URVE
Price
Level
LRAS
This is known as the classical view
of long-run aggregate supply.
Y represents the maximum
capacity of the economy to
produce goods and services i.e.
there is full employment and all
resources are being used
efficiently.
P
Y
Real National Output
FACTORS A FFECTING LRAS (1)
Factor
mobility
refers to the
ease in which
the factors of
production
can be put to
different uses



Long-run aggregate supply can shift when there is a change in
the quantity and/or quality of the factors of production
Land
 If additional land for production becomes available, or
new primary raw materials are discovered or become
available, the productive potential of the economy will
improve and LRAS will increase
Labour
 If there is an increase in the size of the labour force, then
it might be expected that output will increase
 If there is an increase in the quality of the labour force
e.g. through training and education then efficiency and
productivity is enhanced and LRAS will increase
 If there is improved occupational or geographical mobility
of labour this gives firms more flexibility in production
FACTORS A FFECTING LRAS (2)

Economic
incentives such
as higher
prices are the
reasons why
economic
agents strive to
improve the
production
process. This
leads to
greater
productive
capacity.


Capital (technical progress through technology and
productivity)
 An increase in the quantity, quality and productivity of
capital will boost LRAS
 This can often arise from improvements in technology and
improved research and development
Entrepreneurship (enterprise)
 Improved incentives to set up new businesses, or invest in
the development of new goods and services, can lead to a
boost in LRAS
And....Government Intervention
 Governments will often use regulatory frameworks to
improve the level of competition in different markets
 If successful, then greater competition can drive efficiency
gains amongst firms as they strive to maximise their profits
S HIFTS
OF THE
LRAS C URVE
A decrease in the quantity and/or
quality of factors of production will
shift LRAS from LRAS to LRAS2.
Price
Level
LRAS2
LRAS
LRAS1
An increase in the quantity and/or
quality of factors of production will
shift LRAS from LRAS to LRAS1.
P
Y2
Y
Y1
Real National Output
For each of the following examples, identify the impact on LRAS.
Will there be an increase or decrease in LRAS?
Impact
The government introduces new immigration laws
to limit the ability of migrant workers to seek
employment in the UK
The government introduces tax breaks for
companies that invest a portion of their profits in
research and development
An extra £2bn is made available for education and
training
The government raises the retirement age to 70
Pressure groups successfully block the development
of “fracking”
The government invest £1bn to widen broadband
coverage
Increase or
Decrease?
T HE K EYNESIAN AS C URVE

The classical view of LRAS suggests that the economy will always
produce the maximum that its factor resources will allow

Classical economists believe that markets will always function
efficiently over the long-run, and so an economy will produce on
the outer boundary of its production possibility curve, thus the
LRAS curve is vertical, marking a maximum limit of production

John Maynard Keynes however, believed that an economy could
be in equilibrium below full employment

Through his study of The Great Depression of the 1930’s, he
concluded that the LRAS curve was upward sloping, and did
have a vertical section (like the classical LRAS curve), but at
times an economy could settle at a level of output below full
employment
T HE K EYNESIAN AS D IAGRAM
LRAS
Price
Level
C
B = Limited spare capacity
As the economy nears full
employment, firms find it more
difficult to attract scarce
resources, so prices begin to
rise.
B
P
A = Unused capacity
Firms can increase output
without increasing costs.
A
C = Full capacity
There is full employment and
all resources are used.
FE
Real National Output
Draw a production possibility diagram to help explain the LRAS curve.
S HIFTS
Price
Level
IN THE
K EYNESIAN LRAS C URVE
LRAS2 LRAS LRAS1
As per the classical LRAS
curve, any change in
either the quantity or
quality of factors of
production will shift
LRAS.
P
FE2
FE
FE1
Real National
Output
W HICH LRAS C URVE S HOULD Y OU U SE ?

It depends!

It is crucial to understand the difference between the short-run
and long-run aggregate supply curves, this is a common area of
testing Economics papers

In terms of the long-run, you should have an understanding of
both models, as this will allow you to explain and evaluate more
fully the impact of economic policy

The Keynesian version is arguably more “realistic” in its approach
and can often be applied to a range of explanations regarding the
behaviour of an economy, but it is worth noting that neither the
classical nor Keynesian model are free from problems, and both
have a number of assumptions lying behind their theory

The crucial point to note is that they are “models” and should be
used as such, rather than perfect predictors of how an economy
might behave
M ULTIPLE C HOICE 1

Price
Level
LRAS1
LRAS2
Which one of the following
developments is most likely to cause
the shift in the long-run aggregate
supply curve from LRAS1 to LRAS2?
a) Growth in export markets
b) Improvements in the banking
system that increase the funds
available for investment
c) An improvement in consumer
confidence
d) A sustained increase in
government spending on welfare
benefits
Real National Output

Can you explain your answer?
M ULTIPLE C HOICE 2
The shift in the LRAS curve is
most likely to have been caused
by a fall in

Price
Level
LRAS2
LRAS1
a)
the capital stock
b)
income tax rates
c)
the growth of labour
productivity
d)
interest rates
Real National Output

Can you explain your answer?
M ULTIPLE C HOICE 3
All other things being equal, which one of the following is
most likely to cause a simultaneous shift to the right in both
an economy’s short-run and long-run aggregate supply
curves? An increase in

a)
the number of immigrants entering the country
b)
the rate of interest
c)
the rate of VAT
d)
the minimum wage rate

Can you explain your answer?