Aggregate Supply (Edexcel A-Level Economics A): Revision Notes

Aggregate Supply

Introduction to aggregate supply

Aggregate supply represents the total output of goods and services produced within an economy during a specific time period. It differs significantly from individual market supply curves that you may have studied in microeconomics. At the macroeconomic level, we examine the relationship between the overall price level and the total quantity of output supplied across the entire economy.

Understanding aggregate supply requires distinguishing between the short run and the long run. The ability of firms to adjust their output depends heavily on the time period under consideration and the flexibility they have in changing their production inputs.

The short-run aggregate supply curve

In the short run, firms face constraints when attempting to vary their production inputs. Many costs, particularly wages, tend to be fixed. When firms want to increase output quickly, they often must do so by increasing the intensity with which they use existing inputs. For example, a business might pay existing workers overtime or pay premium prices for rapid delivery of raw materials. Firms may be willing to accept these higher costs if they can pass them on through increased prices.

The short-run aggregate supply (SRAS) curve shows the relationship between the overall price level and the amount of output firms are prepared to supply in the short run. This curve is upward sloping, indicating that as the price level rises, firms are willing to supply more output.

Factors shifting the short-run aggregate supply curve

Several factors can cause the SRAS curve to shift, affecting the amount of output firms are willing to supply at any given price level.

Cost of inputs

Changes in the prices of raw materials directly impact production costs. If a key raw material becomes scarce and its price increases, production costs rise. Firms may then choose to supply less output at any given price level, causing the SRAS curve to shift leftward.

Labour costs

Labour represents another key input for firms. An increase in wages raises production costs, which leads to a leftward shift of the SRAS curve. Conversely, if labour costs fall, the curve shifts rightward as firms can profitably supply more output at each price level.

Exchange rate

For firms that rely on imported raw materials, energy, or component parts, changes in the exchange rate affect production costs. If the exchange rate appreciates (strengthens), the domestic price of imports falls, potentially reducing costs and shifting SRAS rightward. If the exchange rate depreciates (weakens), import costs rise, and SRAS shifts leftward.

Government intervention

Government policies can affect firms' costs. Increased regulation requiring greater spending on health and safety measures raises costs, causing a leftward shift of the SRAS curve. Similarly, an increase in corporation tax has comparable effects by reducing the profitability of production at any given price level.

The long-run aggregate supply curve

Economists hold different views about how aggregate supply behaves in the long run. These differences have significant implications for economic policy.

Classical/monetarist view

The classical/monetarist school believed that the macroeconomy always adjusts rapidly toward full employment. They argued that the economy would consistently converge on an equilibrium at the natural rate of output, which represents the long-run equilibrium level of output. Associated with this equilibrium is the natural rate of unemployment.

According to this view, the long-run relationship between aggregate supply and the price level is vertical. This means that changes in the overall price level do not affect aggregate output in the long run because the economy rapidly readjusts back to full employment.

Keynesian view

The Keynesian school held that the macroeconomy was not sufficiently flexible to enable continuous full employment. They argued that the economy could reach equilibrium at a position below full employment, at least in the short to medium term. Inflexibilities in labour markets, particularly if firms held pessimistic expectations about aggregate demand, could prevent adjustment to full employment.

According to Keynesian economists, if firms expected weak demand and reduced their output, this would lead to lower incomes for workers who faced redundancy. This pessimistic outlook could become self-fulfilling, with aggregate demand remaining genuinely deficient.

The shape of the LRAS curve has significant implications for economic policy. A vertical LRAS suggests limited scope for using demand-side policies to affect the economy's path, especially if adjustment to long-run equilibrium occurs rapidly. Conversely, Keynesian economists argued that the economy could become trapped below full employment, requiring policy intervention to restore full capacity utilisation.

Factors affecting the long-run aggregate supply curve

Regardless of whether the LRAS curve is vertical or upward sloping, it is important to understand what factors determine its position. Both classical/monetarist and Keynesian approaches recognise a capacity level of aggregate output, so we need to identify what determines this capacity.

Quantity of inputs

The most direct way to increase potential aggregate output is through an increase in the availability of factors of production. Specifically, increases in labour and capital inputs enable greater production.

Labour supply: The size of the workforce influences aggregate supply position. While workforce size changes relatively slowly, it affects long-run rather than short-run aggregate supply. Migration represents one mechanism through which the workforce expands. For example, the expansion of EU membership in May 2004 led to significant migration into the UK, expanding the workforce and increasing potential output.

Capital: An increase in the quantity of capital also enhances the economy's productive capacity. However, such increases require firms to undertake investment activity. The balance between consumption and investment spending affects the position of the aggregate supply curve in future periods.

Effective use of inputs

Beyond the quantity of inputs, the effectiveness with which they are utilised significantly influences the aggregate supply curve's position. Technological advances provide one route through which inputs can be used more effectively. New machinery can improve efficiency in using other inputs, and the development of new materials can have similar impacts. Such developments reduce firms' costs and increase the amount of aggregate output that can be produced, shifting the long-run aggregate supply curve rightward.

The diagram above illustrates a rightward shift in LRAS, from $\text{LRAS}_0$ to $\text{LRAS}_1$, with corresponding increases in full employment output from $Y_{FE0}$ to $Y_{FE1}$. This shift could result from technological improvements, increases in input quantities, or enhanced input effectiveness.

Transport infrastructure also plays a role. Increased congestion on roads raises transport costs and leads to less efficient input use, raising costs for firms. These effects cause a leftward shift of the aggregate supply curve. Conversely, improvements to infrastructure in the domestic economy, such as transport system enhancements, have the opposite effect by reducing firms' costs and enabling a rightward shift of the aggregate supply curve.

Real-world application: the COVID-19 pandemic