Aggregate Demand and Aggregate Supply

Aggregate Supply

What Is Aggregate Supply?

Aggregate supply is the sum of production in an economy in a specific time period. Aggregate supply behaves differently in the short run and the long run.

Aggregate supply (AS) is the total supply of final goods and services in an economy at a given time. As with aggregate demand, AS can be shown as a curve. The shape of the AS curve depends on the time frame in which it is calculated: short run or long run. In the short run, the AS curve will slope upward because the prices of labor and other inputs to production are constant and supply is susceptible to changes in price levels. In the long run, however, supply is susceptible to changes in the prices of the factors of production, such as labor, raw materials, and infrastructure. Understanding how the behavior of AS is different in the short run and the long run is a crucial component of understanding economic shifts in the short run.

AS is affected by production costs, including the price of labor (wages), taxes, subsidies, and the price of raw materials. The components of production include labor, or the supply of work done by humans in return for wages or other compensation. The supply of labor varies in response to a variety of economic pressures, including skills, mobility, and wages. A natural resource is a a naturally existing form of physical capital that provides inputs to production, such as land, minerals, water, agricultural products, and forests. Entrepreneurship is the activity by companies and individuals bringing products to market.

Considering these factors shows why AS curves behave differently in the short run and the long run. In the short run, AS is upward sloping because the price level does affect the economy's output.

Because the short-run AS is highly influenced by fluctuations in price levels, it is crucial to understanding in economic fluctuations in the short run.

Why the Short-Run Aggregate Supply Curve Slopes Up

Three main theories explain why short-run aggregate supply curves slope upward: sticky wages, sticky prices, and misconceptions.

Short-run aggregate supply is the major factor determining short-run economic behavior. Aggregate supply in the short run is highly influenced by price. The short-run supply curve slopes upward because higher prices lead to greater production, while lower prices diminish production. Companies want to earn profits, or revenue in excess of their costs. Higher prices can mean more profits, so companies increase output to earn more money. There are three main theories for why short-run aggregate supply curves slope upward.

The first is the sticky-wage theory. A sticky wage is a wage that does not change quickly in response to changes in the labor market. The sticky-wage theory explains the upward slope by suggesting that wages only change gradually as economic conditions shift—that is, they stick to their current level and only shift slowly. This is partly because wages are affected not only by economic factors but also by societal norms, values, and political pressures. Wages can also be agreed upon in contract negotiations between workers and employers, and those contracts can last several years. Additionally, wages are set at specific points in time with specific expectations about price and production; in time, the real price might be higher or lower than the expectation, but contracts and wages are not renegotiated constantly in response to price fluctuations. Sticky wages thus intensify the pressure put on production caused by price fluctuations—if prices are lower than expected, companies are driven to produce less, while the opposite is true when prices exceed the expected level.
The short-run aggregate supply (SRAS) curve slopes upward, because a change in price level causes a change in production. Short-run aggregate supply is the total supply of goods and services at a particular price level. An example of the influence of changing price level on production is that a toy manufacturer will increase production when the price at which they can sell their toys increases.
The second theory is the sticky-price theory. This idea suggests that prices, rather than wages, are sticky. A sticky price is a price that does not change quickly in response to shifts in supply or demand. This stickiness is caused in large part by menu costs. A menu cost is a cost incurred when a business changes its prices because consumers can only respond to price if they know what the price is. Companies may set prices at one point, only for an economic downturn to strike afterward. While some companies might reduce prices immediately, others might be slow to do so out of fear of incurring large menu costs. The result is that these slower companies have their prices set too high, and their declining sales force them to cut back on production and employment. Since prices do not always adjust immediately to changing market conditions, these firms incur fewer sales.

The third theory states that misconceptions exist when producers mistake price changes for relative price changes. A relative price is the price of a good or service relative to the price of other goods and services. The misconceptions theory attributes the upward slope, ultimately, to human errors in decision making. Specifically, producers mistake a change in the prices of their own products for a change in the relative prices of goods in the market. Producers respond to these misconceptions of relative price changes by increasing or decreasing production.

Shifts in the Short-Run Aggregate Supply Curve

Shifts in the short-run aggregate supply curve are ultimately caused by changes in labor, capital, natural resources, or technology or by changes in expectations of price levels.

Technology, factor availability, and factor prices are held constant along the short-run aggregate supply (SRAS) curve. If any of these change, the SRAS curve will shift. Shifts in the SRAS curve are the result of changes in the availability or prices of the factors needed to produce goods and services as well as changes in the current level of technology. Changes in input prices, changes in labor, changes in capital, changes in natural resources, and changes in technology all cause the SRAS to shift.

For example, if input prices rise, firms will find the profitability of their current production reduced. For any given level of output to be produced, an increase in the price level will be required to achieve the same level of profitability. If price levels do not increase, firms will react by decreasing production. For the economy as a whole, this means that there will be less output at each price level. Graphically, this is represented by a leftward shift in the SRAS curve.

The SRAS curve will also shift because of a change in labor. An increase in the quantity of labor available will shift the AS curve to the right. A decrease in the labor force will shift the AS curve to the left. An increase in physical or human capital will shift the AS curve to the right, while a decline in either will shift the AS curve to the left. An increase in the level of natural resources or their availability will shift the AS curve to the right. For example, if a new source of oil were found, it would increase the amount of natural resources available. This increased supply of oil would result in lower oil prices and a lower cost of production of goods and services that rely on oil as a factor of production.

An improvement in technology results in increased productivity. With increased labor productivity, the unit costs of production fall as long as wages don’t rise sufficiently to offset the increased productivity. With no increase in factor prices, firms are willing to produce more goods and services at the same price levels. The assembly line is an example of an improvement in technology that resulted in workers producing more at the same wage rate.