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.
Sum of the supply curves of the
industries in the economy.
Distinguish between the short run and
the long run
SHORT RUN
AGGREGATE SUPPLY
CURVE

Graphically the short

run aggregate supply
curve (SRAS) looks
very much a like a
microeconomic supply
curve - upward sloping.
Positive relationship
between price level and
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? (macro)
The period of time when the prices of
the factors of production do not
change.
It’s the FIXED WAGE period
 Short Run Aggregate Supply:
Increasing Output
 HLstudents - the law of diminishing returns
(MC and AVC rise as output increases in the
short run).
Inthe short run, an increase in output
= an increase in AVC and MC.
Industries will pass on an increase in
costs = higher price level.
This explains why the SRAS curve is
upward sloping.
 Shifts in Short Run Aggregate
Supply (SRAS)
Change in anything other than the price
will lead to a shift in the whole curve (a
change in any of the factors)
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
Supply Side Shocks
They are factors that cause changes
in the cost of production.
Similar to microeconomic
analysis:decrease in costs = increase
in AS
increase in costs = decrease in AS.
CHANGES IN THE COSTS OF PRODUCTION
A change in Wage Rates

An increase in unit labour

costs/decrease in productivity = fall in
AS.
IE, the government raised the legal
minimum wage
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

 priceof significant, widely used raw

materials.
 However, a change in the price of oil, would
have an impact on all industries
 Changes in exchange rate (imported raw
materials)

 Find
examples in the news of factors that
would affect AS. Explain.
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
The different-shaped LRAS
curves lie at the basis of
controversies about appropriate
policies to be followed by
governments.

Keynesian economics or
Neo-classical
LONG RUN AGGREGATE
SUPPLY
Two main schools of thought,
concerning the shape of the LRAS.
Approach of John Maynard Keynes –
Keynesian Economics. VS...
neo classical economists or free
market economists (neoliberalism)

Research online and summarise

their beliefs.
KEYNESIAN
LRAS CURVE

The
Keynesian
LRAS
shows
three
possible
phases
KEYNESIAN LRAS SUPPLY
CURVE: Phase 1

AS perfectively elastic at
low levels of economic
activity.

existence of spare capacity

in the economy (higher
output aren’t inflationary).

unused factors
(unemployed labour an
underutilized capital).
KEYNESIAN LRAS SUPPLY
CURVE: Phase2

As the economy
approaches its potential
output (Yf) the economy’s
available factors of
production become
increasingly scarce.

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.
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.
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.
What will cause the LRAS curve to
shift to the right?
 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
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

The word “incentives” is often used in

describing these policies,
Increase productivity for labour force.
They also designed to increase the
incentives for firms to increase productivity.
MARKET ORIENTED SUPPLY SIDE POLICIES

Reduction in Income Taxes

Reductions in Corporation Taxes
Reduction in Trade Union Power
Reduction or elimination of Minimum
Wages
Reduction in Unemployment Benefits
Deregulation
Privatisation

(research,in pair, examples in the

news. Explain their aims, come up with
arguments in favor or against)
 MARKET ORIENTED SUPPLY SIDE POLICIES
Reductions in Trade Union Power

Itif 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
Deregulation
Ifgovernments 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

Allof 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
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)
Itis 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.
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
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.