APMacro: Aggregate Supply

The aggregate supply (AS) curve shows the relationship between the price level and the total amount of real output or RGDP that firms are willing to produce.The shape of the curve depends on whether one is looking at a long-run aggregate supply curve (LRAS) or a short-run aggregate supply curve (SRAS).

LRAS Curve pic

The LRAS curve is a vertical line, reflecting the classical view that wages and prices are flexible, meaning that firms will always produce at the full employment level of output. The LRAS curve is a vertical fixed line at the full employment level of output. The full employment level itself, which is the same as potential GDP, depends on the availability of labor and capital and the state of technology.

Firms have no incentives to produce more or less than the full employment level. They will produce this amount regardless of market prices. If prices go up, wages will increase as well. The cots of production will increase proportionately, and thus there will be no incentive to produce more. Similarly, producers have no incentive to decrease production if prices fall. As prices fall and revenue goes down, wages will also fall and the costs of production will go down by the same amount. The result is no change in profits and no incentive to lower production.

7 AS Curve pic

The SRAS curve is based on the Keynesian belief that prices and wages are sticky, at least in the short run. The result is that firms do have an incentive to produce more as prices go up. Many workers are tied into contracts, and their wages will not increase at once, if at all, when prices go up. Therefore, the costs of production stay the same and firms increase production to take advantage of the higher revenues offered by increased prices. This AS curve slopes upward from left to right and looks like the familiar upward sloping supply curve.

The aggregate supply curve is a relationship between the price level and the RGDP firms produce. This relationship will shift as firms’ cost of doing business change. The factors that would change how much firms supply at a given price are the same factors that shift the AS curve.

9 AS Shifters

A rightward shift in the AS curve means that the supply of all goods and services is increasing. We refer to this as a positive supply shock. It usually occurs when there is economic growth or technological progress. Discoveries of natural resources and changes in the economy that promote production have this effect as well.

The AS can decrease as well. A decline in AS creates a leftward shift of the AS curve and a negative supply shock. For example, a change in the costs of major inputs for firms can create a negative supply shock. Oil, agricultural products, and labor are the most important inputs firms buy. An increase in the price of oil will shift the AS curve to the left. Bad weather that decreases the supply of agricultural products will shift the AS curve to the left as well. Finally, changes in the cost of labor or any other important input, will alter how profitable firms find it to produce at different price levels. Generally, higher wages will shift the AS curve to the left, and lower wages will shift it to the right.



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