Aggregate Supply Curve

What is an Aggregate Supply Curve?

Definition: The aggregate supply curve (ASC) is an economic graph that indicates how many goods and services an economy’s firms are willing and able to produce in a given period.

What Does Aggregate Supply Curve Mean?

What is the definition of aggregate supply curve? The ASC is the sum of all the supply curves for individual goods and services. Therefore, as the individual AS, it represents a direct relationship between the price and the quantity supplied.

In the long-term, the ASC is perfectly vertical because it represents an economy’s potential output with full employment of an economy’s resources. In the short-term, the ASC is upward sloping because as the prices increase, and so do the costs. The ASC is shifts when a change in supply, working capital, natural resources, or occurs.

What is Short Run Aggregate Supply?

Short run aggregate supply shows total planned output when prices can change but the prices and productivity of factor inputs e.g. wage rates and the state of technology are held constant.

In the short run, the aggregate supply curve will react to price level, which means it is upward sloping rather than vertical. If the price level increases, quantity supplied will increase. If the price level decreases, the quantity supplied will decrease. Economists have offered three theories to explain this positive relationship between price and quantity creating an upward sloping curve in the short run. Let’s take a brief look at each.

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 AD falls we see a contraction of SRAS.

Short Run Aggregate Supply Curve
Short Run Aggregate Supply Curve

Shifts in Short Run Aggregate Supply (SRAS)

Shifts in the position of the short run aggregate supply curve in the price level / output space are caused by changes in the conditions of supply for different sectors of the economy:

  • Employment costs e.g. wages, employment taxes. Unit labour costs are also affected by the level of labour productivity
  • Costs of other inputs e.g. commodity prices, raw materials. The exchange rate can affect the prices of key imported products
  • Impact of government e.g. environmental taxes such as carbon duties & business regulations which affect the costs of production

Analysis diagram of shifts in aggregate supply

Shifts in Short Run Aggregate Supply
Shifts in Short Run Aggregate Supply

What are the main causes of shifts in aggregate supply?

The main cause of a shift in the aggregate supply curve is a change in business costs – for example:

  1. Changes in unit labour costs – i.e. labour costs per unit of output
  2. Changes in other production costs: For example rental costs for retailers, the price of building materials for the construction industry, a change in the price of hops used in beer making or the cost of fertilisers used in farming.
  3. Commodity prices changes to raw material costs and other components e.g. the prices of oil, natural gas, electricity copper, rubber, iron ore, aluminium and other inputs will affect a firm’s costs
  4. 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
  5. Government taxation and subsidies:
    • An increase in taxes to meet environmental objectives (known as green taxes) will cause higher costs and an inward shift in the SRAS curve – for example a higher price for carbon emissions
    • Lower duty on petrol and diesel would lower costs and cause an outward shift in SRAS
  6. The price of imports:
    • Cheaper imports from a lower-cost country has the effect of shifting out SRAS
    • A reduction in an import tariff on imports or an increase in the size of an import quota will also boost the supply available at each price level causing an outward shift of SRAS

What is Long Run Aggregate Supply?

Long run aggregate supply shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked to the production possibility frontier

  • In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change when the general price level changes)
  • In the short run, the SRAS 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).

The aggregate supply curve is completely vertical in the long run. The total production of goods and services in an economy is its real gross domestic product (GDP). In the long-run, GDP depends on the supply of labor, capital, land, natural resources, and the availability of technology to turn these resources into goods and services. In the long run, these factors of production determine the quantity of goods and services that are supplied in an economy. This quantity is the same regardless of a price level.

But, you may be asking yourself why the supply curves for individual goods or services are upward sloping instead of vertical. The upward slope of the supply curve for specific goods or services has to do with relative prices, which are simply the prices of goods and services compared to other goods and services. A business can take advantage of relative prices to increase production of a specific good or service.

Let’s say that you own an industrial bakery where you mass-produce donuts and cinnamon rolls. The market price of donuts has increased. Assuming that the other prices in the economy remain constant, you can shift your labor and ingredients away from production of cinnamon rolls to donuts. In contrast, an entire economy’s production is limited by available labor, capital, land, and natural resources. When prices rise at the same time in economy, there can be no change in the overall quantity of goods or service produced; you can shift production around, but the numbers remain the same because we are dealing with aggregates.

Example

In the short-term, the aggregate supply curve follows the pattern of the individual supply curves, which is upward sloping. This happens because as the prices rise, consumers spend less money because of the higher costs. At the lower levels of consumer demand, producers supply a greater amount of output due to the law of diminishing returns, thereby keeping the average price stable. However, as the demand increases, producers raise their prices, thus lowering demand.

Consequently, a rise in the production costs shifts the ASC to the right, whereas a decrease in the production costs shifts the ASC to the left. Other determinants that influence the ASC in the short-run are taxes, wages, the price of raw materials, the quantity of labor and the quantity of capital employed.

In the long-term, the ASC is perfectly vertical proving that changes in aggregate demandcan only temporarily change the total output of an economy. In fact, the supply curve in the long-term is influenced by changes in the labor, capital, and technology because it is assumed that the economy is using all of its resources optimally.

Summary Definition

Define Aggregate Supply Curve: ASC means a graph showing the overall supply of goods and services that producers are willing and able to produce in the economy.