12.

Understanding Aggregate Supply

What do we mean by aggregate supply? Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, AS represents the ability of an economy to deliver goods and services either in the short-term or in the long-term. The nature of this relationship will differ between the long run and the short run Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are assumed to be held constant. Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average wage rates can change it is a measure of a countrys potential output and the concept is linked strongly to that of the production possibility frontier o o In the long run, the AS curve is assumed to be vertical (i.e. it does not change when the general price level changes) In the short run, the AS curve is assumed to be upward sloping (i.e. it is responsive to a change in aggregate demand reflected in a change in the general price level)

This all sounds a bit technical at the moment but as we will see, the easiest way to think about AS is simply to think about the costs of producing different goods and services in the economy. The short run aggregate supply curve

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General Price Level

LRAS

P3

An expansion of national output

P2

A contraction of national output

P1

The short run AS curve is upward sloping because higher prices for goods and services make output more profitable and enable businesses to expand their production by hiring less productive labour and other resources

SRAS

Y1

Y2

Yfc

Real National Income

A change in the price level brought about by a shift in AD results in a movement along the short run AS curve. If AD rises, we see an expansion of SRAS; if demand falls we see a contraction of SRAS. The slope of SRAS curve depends on the degree of spare capacity in the economy. 1. Negative output gap: At low levels of real national income where actual GDP < potential GDP, many businesses have a lot of spare capacity and can easily and quickly expand production without paying their workers overtime or coming up against other supply bottlenecks. The SRAS curve is therefore drawn as elastic (in the diagram this might be a movement from Y1 to Y2). 2. Positive output gap: As national output expands and the economy heads towards full capacity, so producers may find it harder to raise production. Workers receive the same basic wage rate but require payment of overtime and bonuses to work longer hours and increase GDP SRAS is becoming more inelastic (e.g. shown from the movement between Y2 and Yfc where Yfc is drawn as a full-capacity level of national output). 3. Diminishing returns? As national output expands, older less productive machinery may be used and less efficient workers hired. 4. Full-capacity output at LRAS. Eventually the economy cannot increase the volume of output further in the short-term. At this point SRAS is perfectly inelastic at Yfc the economy has reached full-capacity (the LRAS curve)

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General Price Level

P3

LRAS

P2

Short run aggregate supply is inelastic here a rise in AD will have more of an effect on the general price level than it will on the volume of real national output

P1

SRAS

Short run aggregate supply is elastic here because there is plenty of spare productive capacity (i.e. the output gap will be negative). A rise in AD will lead easily to an expansion of real national output

Y1

Y2

Yfc

Real National Income

Shifts in short run aggregate supply (SRAS) Shifts in the SRAS curve can be caused by the following factors 1. Changes in unit labour costs: Unit labour costs are defined as wage costs adjusted for the level of productivity. For example a rise in unit labour costs might be brought about by firms paying higher wages or a fall in the level of productivity. If unit wage costs rise, this will feed through into higher prices (this is known as cost-push inflation) 2. Commodity prices: Changes to raw material costs and other components e.g. the world prices of oil, copper, aluminium and other inputs will affect a firms costs. 3. Exchange rates: Costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas 4. Government taxation and subsidies: Changes to producer taxes and subsidies have effects on the costs of nearly every producer for example an increase in taxes designed to meet environmental objectives will cause higher costs and an inward shift in the SRAS curve. Conversely a reduction in the duty on petrol and diesel might lower costs and cause an outward shift in SRAS. 5. A change in the level of international trade: An increased availability of cheaper imports from a lower-cost country has the effect of shifting out SRAS. In a similar fashion, a reduction in a tariff on imports or an increase in the size of an import quota will also boost the supply available at each price level. 6. Education and skills changes: A more highly skilled labour force can affect production costs and supply as can decisions made by people about when to enter the labour force. 7. Regulation changes: Government regulations can in some circumstances have an effect on aggregate supply. An example might be the deregulation of a market which encourages the entry of new producers either from the domestic or the international economy.

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Changes in global commodity prices have been much in the news over the last couple of years. Producers not just in the UK but throughout the world have been affected by sizeable increases in the costs of many inputs such as copper, steel, rubber, oil and gas, other metals and foodstuffs. The result has been a major squeeze on costs and profits. Some firms have been able to pass on higher costs to customers further down the supply-chain. Others have not leading to fears of a sharp rise in cost-push inflation contributing to a wider economic slowdown. Shifts in the short run aggregate supply curve are illustrated in the diagram below

General Price Level

LRAS

SRAS1 SRAS2: A fall in aggregate supply caused by an increase in costs less output can be supplied at each and every price level SRAS1 SRAS3: A rise in aggregate supply caused by a fall in production costs more output can be supplied at each and every price level

SRAS2

SRAS1

SRAS3

Yfc

Real National Income

The current state of the world economy means that study of what brings about shifts in short run aggregate supply is particularly relevant. We have seen a major change in the prices of many essential inputs as shown by the sharp rise in the Economists Commodity Price Index. Oil and gas prices are the obvious sign of this with the price of crude oil more than doubling during 2007-08. Have we now reached an end to the era of cheap energy? Will global food prices fall or will they stay high for the foreseeable future? If this is the case, businesses in many different sectors of the economy are going to have to adjust to a world where the prices of many of their components and other inputs are much higher than before. Short test exercise on aggregate supply Here is a series of economic events. Decide whether they are likely to cause an outward or an inward shift in SRAS. Or (if you think the event affects aggregate demand) a movement along the SRAS curve.
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Economic Event

Impact on SRAS
Outward shift / inward shift / movement along SRAS

An increase in wage costs due to a rise in the National Minimum Wage from 5.00 per hour to 5.80 per hour A fall in the price of oil from $145 a barrel to $100 a barrel An increase in consumer demand for consumer durables caused by lower interest rates An increase in the rate of value added tax imposed on producers from 17.5% to 20.0% An appreciation (rise) in the value of the pound against the US dollar by 15% Fall in unit wage costs brought about by an influx of migrant workers into the UK economy A sharp rise in the price of gas and electricity in the wholesale energy markets caused by a period of severe winter weather A fall in the cost of semi conductors used in the computer industry and other industries

2 3

Long run Aggregate Supply (LRAS) We now turn our attention to aggregate supply in the long run. In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology and the availability and quality of factor inputs. A long run production function for a country is often written as follows: Y*t = f (Lt, Kt, Mt) o o o o o Y* is a measure of potential output t is the time period L represents the quantity and ability of labour input available Kt represents the available capital stock Mt represents the availability of natural resources

LRAS is determined by the stock of a countrys productive resources and by the productivity of factor inputs (labour, land and capital). Changes in the technology also affect potential real national output.
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The vertical long-run aggregate supply curve (LRAS) LRAS is assumed to be independent of the price level and is drawn vertical. Neo-classical economists view the LRAS curve as being perfectly inelastic at a level of output where actual GDP has achieved its potential. There will be no unused labour in that all those who are available for employment at the prevailing wage rate will have work in other words, a full-employment level of national income has been reached. Keynesian economists disagree they believe that an economy can settle at a level of output where there are many people still unemployed because of a lack of AD. They argue for active demand-management using tools such as fiscal and monetary policy. Causes of shifts in the long run aggregate supply curve Any change in the economy that alters the natural rate of growth of output shifts LRAS. Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause the LRAS curve to shift out. This is shown in the diagram below.
General Price Level

LRAS1

LRAS2

LRAS3

SRAS1 SRAS2 SRAS3

YFC1

YFC2

YFC3

Real National Income

Policies to increase LRAS

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1. Expanding the labour supply - e.g. by improving incentives for people to search for and then accept jobs as they become available. The UK government has also been encouraging an influx of migrants which has added to the supply of labour although it has created concerns about some of the social and political effects. There are some signs that the big influx of migrant workers into the UK is coming to an end. In the long term many countries must find ways of overcoming the effects of an ageing population 2. Increase the productivity of labour e.g. by investment in training of the labour force and improvements in the quality of management of human resources. 3. Improve mobility of labour to reduce certain types of unemployment for example structural unemployment which is caused by occupational immobility of labour. If workers have better skills and increased flexibility, they will find it easier to get work when economic conditions change. Conversely when unemployment remains high, the economy loses out on potential output and there is a waste of scarce economic resources. 4. Expanding the capital stock i.e. increase the level of investment and research and development. 5. Increase business efficiency by promoting greater competition within markets. 6. Stimulate a faster pace of invention and innovation this will hopefully in the long term promote lower production costs and also improvements in the dynamic efficiency of markets. For most advanced nations it is indeed the growth of productivity that is critical to raising the long term growth of real GDP. The following article refers to what is commonly known as the productivity gap between the UK and other leading industrialized economies. UK productivity still trails competitors Gordon Brown's ambition of matching the growth in productivity of the world's big economies appears as elusive as ever after research by the Centre for Economic Performance showed that in terms of output per hour worked, Britain still lags behind Germany by 13 per cent, the US by 18 per cent and France by 20 per cent. "This means that if we could reach French productivity levels, we could award ourselves 20 per cent higher wages or take a day off and still earn the same. Or we could spend the extra resources on schools and hospitals," according to the reports author. The lag in productivity was mainly due to "deficits in innovation, skills and management practices, as well as regulatory constraints in the retail sector," according to the report. The proportion of lowskilled people in the UK was three times higher than in the US and almost double the proportion in Germany and Japan. Source: Adapted from Financial Times, June 2007

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Aggregate supply shocks We saw in our chapter on AD that external events in the world economy can cause shocks to the level of demand for goods and services. Unpredictable shocks are even more frequent when it comes to aggregate supply. Aggregate supply shocks might occur when there is o A sudden rise in oil prices or other essential inputs such as foodstuffs used in foodprocessing industries. Foodstuffs are an example of intermediate products items that are used up in manufacturing goods for consumers to buy The invention and diffusion of a new production technology A major change in the movement of migrant workers from one economy to another

o o

The obvious recent example is what has happened to the world price of crude oil. Our chart tracks the daily price for West Texas Intermediate, widely regarded as one of the benchmarks for international oil prices. Having been remarkably low in the early years of this decade reaching as low as $17 a barrel in the autumn of 2001, we have seen a dramatic rise in the price of crude. At the time of writing, a barrel of crude oil was selling for just over $145!

West Texas Intermediate Crude Oil

US dollars per barrel, one month futures price, NYMEX
150 140 130 120 110 100
USD/Barrel

150 140 130 120 110 100 90 80 70 60 50 40 30 20 May 03 Sep Jan May 04 Sep Jan May 05 Sep Jan May 06 Sep Jan May 07 Sep May 08 Source: Reuters EcoWin Jan

90 80 70 60 50 40 30 20 Jan

How much of this incredible increase in price has been due to speculative buying of oil by investors such as hedge funds. And how much can be explained by fundamental demand and supply-side reasons which drive the equilibrium price higher, is open to question. Global oil demand has been rising strongly largely on account of the rapid economic growth in emerging market countries such as China and India. But prices have risen because of shortages of oil refining capacity and signs that OPEC and non-OPEC oil producers are finding it more expensive to extract oil from known fields. The result has been a spike in world oil prices that has had huge
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consequences around the global economy. We may be less dependent on oil than we were thirty or more years ago when the first of the big oil-price shocks occurred. But oil remains a key input into many industries and had a direct impact on the prices we pay for transport and heating. This has been a major supply-side shock for the UK economy with demand-side consequences too! The effects of supply-side shocks are normally to cause a shift in the SRAS curve. But there are also occasions when changes in production technologies or step-changes in the productivity of factors of production that were not expected, feed through into a shift in the long run aggregate supply curve. Natural disasters and political conflicts including civil wars can also have a significant effect on a countrys productive potential and therefore affect the LRAS although it is often difficult to measure accurately just how damaging these events have been. Key terms Classical LRAS The classical LRAS curve is drawn as vertical because classical economists argue that the productive capacity of the economy is determine by factors other than price and demand. An unpredictable event which creates a disturbance for the economy Changes to products or production processes innovation is very important in delivering improvements in dynamic efficiency Products used up in manufacturing a final good or service for example wheat used in manufacturing cereals or steel used in supplying new cars How many goods and services an economy can supply in the long run A measure of efficiency e.g. measured by output per person employed or output per person-hour The long run average growth rate mainly determined by changes in the stock of available factor inputs and also improvements in productivity Labour costs per unit of output

External shock Innovation Intermediate goods Productive potential Productivity Trend growth Unit wage costs

Suggestions for further reading on short run aggregate supply Each of these articles has been chosen because it links in with some of the concepts and themes of this chapter on aggregate supply. Dry cleaners hit by rising costs (BBC news, June 2008) Fuel costs push up inflation (BBC news, June 2008) High oil prices hit global economies (BBC news, June 2008) The end of cheap clothes is near (BBC news, April 2008) UK manufacturers raising prices (BBC news, June 2008) Suggestions for further reading on long run aggregate supply Building BRICS of growth (The Economist, June 2008) Contrasting views on EU migration (BBC news, April 2008)
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Innovation in the National Health Service (BBC news, July 2008) Inward investment success for the UK (BBC news, July 2008) UK plans big wind power expansion (BBC news, June 2008) US workers top productivity table (BBC news, October 2007)

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