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AGGREGATE
SUPPLY
ECONOMICS – A COURSE COMPANION
BLINK & DORTON, 2007. p179-185.
Introduction to Aggregate Supply
Definition
• Aggregate Supply is the total amount of goods
and services that all industries in the economy
will produce at a given price level.
• It is essentially the sum of the supply curves of
the industries in the economy.
• In contrast to aggregate demand, it is necessary
to distinguish between the short run and the
long run when looking at aggregate supply.
SHORT RUN AGGREGATE
SUPPLY CURVE
Graphically the short run
aggregate supply curve
(SRAS) looks very much a
like a microeconomic
supply curve in that it is
upward sloping. There is
a positive relationship
between the price level
and the amount of
output that a country’s
industries will supply.
Short Run Aggregate Supply
• At any given price level, industries will supply
a certain level of output.
What is the short run?
• In macroeconomic analysis, the short run is
defined as the period of time when the prices
of the factors of production do not change.
• Most importantly, the price of labour, (the
wage rate) is fixed.
Short Run Aggregate Supply:
Increasing Output
• If a larger level of output is produced, firms
are likely to face higher average costs of
production.
• In order to produce more, firms will have to
provide incentives to workers to produce a
larger amount.
• Most commonly this is done by paying
“overtime” wages. This might be one and half
times the normal wage and so costs rise.
Short Run Aggregate Supply:
Increasing Output
• HL students should recall the law of diminishing
returns. Marginal and average costs will rise as
output increases in the short run.
• In the short run, an increase in output will be
accompanied by an increase in average costs.
• Industries will pass on an increase in costs in the
form of a higher price level.
• This explains why the SRAS curve is upward
sloping.
Shifts in Short Run Aggregate Supply
(SRAS)
• Just as with the microeconomic supply curve,
a change in anything other than the price will
lead to a shift in the whole curve.
• Thus a change in any of the factors, other than
the price level, will result in a shift of the SRAS
curve.
• This may be referred to as “supply side
shocks”
SHIFTS IN SHORT RUN
AGGREGATE SUPPLY
This graph shows
an increase in the
short-run
aggregate supply
from SRAS1 to
SRAS2 and a
decrease in SRAS
from SRAS1 to
SRAS3.
Supply Side Shocks
• The most straightforward explanation of
supply-side shocks is that they are factors that
cause changes in the cost of production.
• Similar to microeconomic analysis, a decrease
in costs results in an increase in aggregate
supply while an increase in costs results in a
decrease in aggregate supply.
CHANGES IN THE COSTS OF PRODUCTION
A change in Wage Rates
• An increase in wages will result in an increase in
the cost of production to firms, and therefore a
fall in aggregate supply.
• If for example, the government raised the legal
minimum wage, it would increase labour costs.
• If labour unions were to negotiate higher wages
for workers as part of enterprise bargaining, this
would also results in a fall in the SRAS.
CHANGES IN THE COSTS OF PRODUCTION
A change in the costs of raw materials
• For a change to have an effect on aggregate
supply, we are assuming an increase in the price
of significant, widely used raw materials.
• An increase in the price of rubber would affect
industries that use rubber as a factor, but this
might not be significant enough to affect
aggregate supply noticeably.
• However, a change in the price of oil, would have
an impact on all industries, as oil is widely used in
most production processes.
CHANGES IN THE COSTS OF PRODUCTION
A change in the price of imports
• If the capital or raw materials used by the
country’s industries are imported, then a rise
in import prices will increase the costs of
production.
• This can occur due to changes in the exchange
rate of a country’s currency.
Combining AD & AS in the Short Run
• The economy will operate where aggregate
demand is equal to aggregate supply.
SRAS & AD IN THE
SHORT RUN
At the average price
level (PL), all the output
produced by the
country’s producers is
consumed. There is no
incentive for producers
to either increase
output or raise prices.
LONG RUN AGGREGATE SUPPLY
• There is considerable debate among
economist regarding the long rung
aggregate supply curve (LRAS).
• The different-shaped LRAS curves lie at
the basis of controversies about
appropriate policies to be followed by
governments.
LONG RUN AGGREGATE SUPPLY
There are two main schools of thought,
concerning the shape of the LRAS.
• The approach of the famous economist
John Maynard Keynes – Keynesian
Economics. VS...
• The approach of neo classical
economists or free market economists
KEYNESIAN LRAS
CURVE
The
Keynesian
LRAS shows
three
possible
phases
KEYNESIAN LRAS SUPPLY
CURVE: Phase 1
In this view the aggregate
supply curve will be
perfectively elastic at low
levels of economic activity.
Producers in the economy
can raise their levels of
output without incurring
higher average costs
because of the existence of
spare capacity in the
economy. That is, there are
high levels of unused factors
such as unemployed labour
an underutilized capital.
Should there be a need for
greater output these can be
used to their fullest capacity
at constant average costs.
KEYNESIAN LRAS SUPPLY
CURVE: Phase2
As the economy approaches
its potential output (Yf) and
the spare capacity is “used
up” the economy’s available
factors of production
become increasingly scarce.
As producers continue to try
to increase output, they
have will have to bid for the
increasingly scarce factors.
Higher prices for the factors
of production mean higher
costs for the producers, and
the price level will rise to
compensate for the higher
costs. A upward sloping
LRAS curve can be seen at
phase 2.
KEYNESIAN LRAS SUPPLY
CURVE: Phase 3
When the economy
reaches its full capacity
(Yf) it is impossible to
increase output any
further because all
factors of production
are fully employed. This
suggests that the LRAS
is perfectly inelastic as
shown in phase 3.
Full Capacity in an Economy
• Full capacity of the economy is shown as Yf.
• This is really a simplification
• This level of output is known as the “full
employment level of output”
• It is important to understand that full
employment does not mean that there is no
unemployment at all.
NEO CLASSICAL LRAS
• Neo-classical economists, also known as free
market economists, do not really acknowledge
or accept the first two stages of the Keynesian
supply curve.
• It is the assumption of the neo-classical
school, that the LRAS curve is vertical at all
price levels, even at very low price levels.
• Thus the LRAS curve is independent of the
price level
NEO CLASSICAL LRAS CURVE
The LRAS curve is
independent of
the price level.
The price level
may rise from P1
to P2, but the
level of output
does not change.
THE LRAC CURVE:
THE DIFFERENCE BETWEEN THE NEO-CLASSICAL AND KEYNESIAN
PERSPECTIVE:
NEO-CLASSICAL PERSPECTIVE
We can only increase national income by
new supply policies even during periods
of low aggregate demand. Price level is
not relevant
KEYNESIAN PERSPECTIVE
We can increase aggregate demand
without the need for supply side
policies, when starting from a position
of low demand.
SHIFTS IN LRAS
• As a country’s factors of production are
constantly changing, we would expect to see
steady increases in its LRAS.
• This is effectively an illustration of potential
economic growth.
• An outward shift of a country’s LRAC curve means
that its productive potential has increased.
• In fact, a shirt in the LRAS curve can be likened to
an outward shift of the production possibilities
curve. (PPC)
A shift in the LRAS curve can be shown from
a either a Keynesian perspective or a neo
classical perspective.
SHIFTS IN THE LRAC CURVE
The increase in the
full employment
level of output is
equivalent to the
outward shift of
the PPC.
(Production
Possibilities Curve)
What will cause the LRAS curve to
shift to the right?
• The LRAS curve will shift to the right if there is an
improvement in the quality of the factors of
production or an increase in the quantity of the
factors of production.
• For example, technological advances might make
capital more productive, thus shifting the LRAS
curve.
• Improvements in education might make existing
labour more productive.
• Discoveries of new sources of raw materials will
increase the quantity of goods produced.
What will cause the LRAS curve to
shift to the right?
• Increasing the quantity of the labour force will
also shift out the LRAS.
• Government policies that are put in place to
increase the long-run aggregate supply of the
economy are known as supply-side policies.
SUPPLY SIDE POLICIES
• The overarching goal of supply side policies is
to increase the potential output of the
economy by increasing the quantity of the
factors of production and or improving the
quality of the factors of production.
Supply side policies can be divided into two
categories:
• Market Oriented policies
• Interventionist policies
MARKET ORIENTED SUPPLY SIDE POLICIES
• These policies focus on allowing markets to
operate freely with minimal government
intervention.
• The word “incentives” is often used in
describing these policies, as they are designed
to increase the incentives for labour to work
hard and more productively.
• They also designed to increase the incentives
for firms to increase productivity.
MARKET ORIENTED SUPPLY SIDE POLICIES
There are several market oriented supply side
policies including:
• Reduction in Income Taxes
• Reductions in Corporation Taxes
• Reduction in Trade Union Power
• Reduction or elimination of Minimum Wages
• Reduction in Unemployment Benefits
• Deregulation of Labor Markets/business laws
(eg: 35 hour work week in France must end. Retirement
age / it needs to be easier to hire and fire workers.
• Privatisation (eg: China state owned industries)
MARKET ORIENTED SUPPLY SIDE POLICIES
Reduction in Income Taxes
• If people work harder and make more money
it is possible that they will have to pay higher
taxes on the higher levels of income.
• This may act as a disincentive to work.
• If taxes are reduced, it is hoped that there will
be greater incentive for labour to work harder
and to become more productive, thus
increasing the potential output of the
economy.
MARKET ORIENTED SUPPLY SIDE POLICIES
Reductions in Corporation Taxes
• If businesses are able to keep more of their
profits, then they will have more money available
for investment (Well at least in theory!)
• As investment is the addition of capital stock to
the economy, this will increase the potential
output of the economy.
• Moreover, if business know that they are going to
be able to keep a larger share of their profits,
rather than give it to the government in taxes,
then they will have more incentive to produce
efficiently.
MARKET ORIENTED SUPPLY SIDE POLICIES
Reductions in Trade Union Power
• It if often perceived that trade unions push wages
up too high and increase the costs of production
to firms.
• Following this, it can be argued that a reduction
in trade union power will reduce the ability of
unions to negotiate high wages and therefore
lower the costs of production to firms, thus
increasing their potential output.
Argument Against
• However, one of the main goals of unions is to
protect the rights of workers, and reduced union
power, may result in worker exploitation.
MARKET ORIENTED SUPPLY SIDE POLICIES
Reduction or Elimination of Minimum Wages
• It can be argued that a government set minimum
wage keeps the price of labour above its free
market level.
• If the minimum wage were to be abolished, then
this would also decrease the costs of production
and increase aggregate supply.
Argument Against
• While this might provide some benefit in terms of
the overall growth of the economy, it will reduce
living standards for those workers on the
minimum wage.
MARKET ORIENTED SUPPLY SIDE POLICIES
Reduction in Unemployment Benefits
• If unemployed people are given generous
unemployment benefits from the government, it
may be argued that they have less incentive to
find jobs.
• Market oriented supply-side economists would
recommend that unemployment benefits be
reduced to encourage unemployed people to
take the available jobs in the economy.
• Of course this policy is only appropriate if jobs are
available.
MARKET ORIENTED SUPPLY SIDE POLICIES
Deregulation
• If governments have placed many regulations on the
operations of business, then this may increase their
costs of production, thereby reducing aggregate supply
in the economy.
• A reduction in the number and or severity of the
regulation (deregulation) will lower business costs and
increase aggregate supply.
Argument Against
• Unfortunately this might include reduced regulations
on safety or environmental standards and this can have
negative consequences for workers and the
environment.
MARKET ORIENTED SUPPLY SIDE POLICIES
Privatisation
• This is the sale of public, government owned
firms to the private sector.
• According to market oriented economists,
privately owned profit-maximising firms will
be much more efficient and productive than
government run firms.
• They will have incentive to increase potential
output.
Argument Against
??
MARKET ORIENTED SUPPLY SIDE POLICIES
Summary
• All of the policies previously mentioned
emphasize the reduced role of the
government in the economy and the
importance of allowing all markets, especially
labour markets to operate freely.
INTERVENTIONIST SUPPLY SIDE POLICIES
• As the name suggests, there policies are based
on the idea that the government has a
fundamental role to play in actively
encouraging growth. They include the
following:
• Education & Training
• Research & Development (R&D)
• Provision of Infrastructure
• Improved Information
INTERVENTIONIST SUPPLY SIDE POLICIES
Education and Training
• In order to constantly increase the quality of labour, it is the
responsibility of the government to ensure that education
and training facilities are geared to providing the necessary
skills and knowledge for a dynamic economy.
• This is related to both the skills and knowledge that young
people need to help them enter the labour force and also
the retraining of workers to help them enter the labour
force.
• It also involves the retraining of workers to help them
adjust to changing economic circumstances.
• Such training can take places in schools, universities,
training institutions and apprenticeship programmes.
INTERVENTIONIST SUPPLY SIDE POLICIES
Research & Development (R&D)
• It is important that an economy’s firms are
able to stay up to date with modern
developments to develop new production
techniques and to constantly seek improved
methods of production.
• All of these may increase the economy’s
potential output, but all involve extensive
spending on R&D.
INTERVENTIONIST SUPPLY SIDE POLICIES
Research & Development (R&D)
Tax Incentives
• Governments can actively encourage R&D by
firms by offering tax incentives.
• For example, they could allow firms not to pay
taxes on the retained profits used for R&D.
• This is known as a tax credit.
• Firms may be reluctant to spend on R&D if they
think they will not be able to reap the full
benefits of their spending.
INTERVENTIONIST SUPPLY SIDE POLICIES
Research & Development (R&D)
• Governments can also encourage R&D by
guaranteeing intellectual property rights such
as patents and copyrights.
• Alternatively governments themselves could
finance R&D in public research facilities and
universities.
INTERVENTIONIST SUPPLY SIDE POLICIES
Provision of Infrastructure
• The productive potential of an economy will
be enhanced by improved infrastructure, such
as better transportation linkages and
telecommunications.
INTERVENTIONIST SUPPLY SIDE POLICIES
Improved Information
• Governments can finance trade fairs to
facilitate the sharing of expertise and
information among a country’s firms.
INTERVENTIONIST SUPPLY SIDE POLICIES
At what cost??
• All interventionist policies have significant
costing implications and governments must
weigh up the opportunity costs of such
spending.
• The benefits of such spending are likely to be
more evident in the long term than in the
short term.
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EXAMINATION QUESTIONS
Short Response Questions (10 marks each)
1.
With the help of a diagram, explain
three possible causes of a decrease in
the SRAS curve.
2.
With the help of diagrams, explain the
difference between the Keynesian LRAC and
the neo- classical LRAC.
3.
How might a reduction in taxes be considered
both a demand-side policy & a supply side
policy.
EXAMINATION QUESTIONS
Essay Question
1a. Using a diagram, explain the
concept of potential economic
growth (10 marks)
1b. Evaluate three policies that might
be used to increase LRAS.