Aggregate Supply

What is Aggregate Supply?

Definition: Aggregate supply (AS) is the total real output of goods and services, including consumer goods and capital goods, that firms produce and supply at a given price level during a specified period of time.

In economics, aggregate supply (AS) or domestic final supply (DFS) is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing and able to sell at a given price level in an economy.

What Does Aggregate Supply Mean?

What is the definition of aggregate supply? The aggregate supply curve show that at a higher price level across the economy, firms are expected to supply more of their goods and services at higher prices. Any increase in the costs of production lead to an increase in the general price level and therefore, firms expect that they will benefit from higher prices, at least in the short-run.

In this context, modern economists separate the short-term aggregate supply from the long-term aggregate supply because the short-term AS begins following an increase in the general price level and ends when the cost of production has increased.

This allows the firms to produce more output, therefore increasing the aggregate supply. In contrast, the long-term AS is related only to improvements in productivity and efficiency, and not to the general price level.

Different Scopes

There are generally three alternative degrees of price-level responsiveness of aggregate supply. They are:

  1. Short-run aggregate supply (SRAS) — During the short-run, firms possess one fixed factor of production (usually capital), and some factor input prices are sticky. The quantity of aggregate output supplied is highly sensitive to the price level, as seen in the flat region of the curve in the above diagram.
  2. Long-run aggregate supply (LRAS) — Over the long run, only capital, labour, and technology affect the LRAS in the macroeconomic model because at this point everything in the economy is assumed to be used optimally. In most situations, the LRAS is viewed as static because it shifts the slowest of the three. The LRAS is shown as perfectly vertical, reflecting economists’ belief that changes in aggregate demand (AD) have an only temporary change on the economy’s total output.
  3. Medium run aggregate supply (MRAS) — As an interim between SRAS and LRAS, the MRAS form slopes upward and reflects when capital, as well as labor usage, can change. More specifically, medium run aggregate supply is like this for three theoretical reasons, namely the Sticky-Wage Theory, the Sticky-Price Theory and the Misperception Theory. The position of the MRAS curve is affected by capital, labour, technology, and wage rate.

In the standard aggregate supply-aggregate demand model, real output (Y) is plotted on the horizontal axis and the price level (P) on the vertical axis. The levels of output and the price level are determined by the intersection of the aggregate supply curve with the downward-sloping aggregate demand curve.

Aggregate supply
Aggregate supply

Example

Manufacturing firms supply 100 tons of a particular good when the production costs total to $376,000. If the production costs rise to $581,000, these firms will be required to lower the supply of this particular good because the general price level of the economy will rise. At the same time, the labor costs total up to $30,500.

If the labor costs rise to $41,200, the firms will lower their production. Furthermore, if these firms are importing raw materials, an increase in the exchange rates will cause the prices of raw materials to rise, and vice versa. On the other hand, a decrease in an import tariff will cause a rise in aggregate supply.

Assume that the government imposes a green tax to protect the environment. This will cause higher costs for the firms, especially those involve in carbon emissions. On the other hand, a lower tax on oil would increase the aggregate supply of oil products, as the firms involved in the oil production will have lower costs, therefore increasing their output.

Components of Aggregate Supply

Consumer goods

Private consumer goods and services, such as motor vehicles, computers, clothes and entertainment, are supplied by the private sector, and consumed by households. For a developed economy, this is the single largest component of aggregate supply.

Capital goods

Capital goods, such as machinery, equipment, and plant, are supplied to other firms. These investment goods are significant in that their use adds to capacity, and increases the economy’s ability to supply private consumer goods in the future.

Public and merit goods

Goods and services produced by private firms for use by central or local government, such as education and healthcare, are also a significant component of aggregate supply. Many private firms such as those in construction, IT and pharmaceuticals, rely on contracts to supply to the public sector.

Traded goods

Goods and services for export, such as chemicals, entertainment, and financial services are also a key component of aggregate supply.

Four Factors of Aggregate Supply

The amount supplied is determined by the four factors of supply. The amount supplied is called the natural rate of output. Short-run economic fluctuations can occur without affecting the long-run output rate.

The following four factors determine long-run supply.

  1. Labor. The people who work for a living. The value of labor depends on workers’ education, skills, and motivation. The reward or income for labor is wages. The United States has a large, skilled, and mobile labor force that responds quickly to changing business needs. But it faces increasing competitive labor from other countries. They provide similarly-skilled workers at a lower price. This is why American jobs are being outsourced.
  2. Capital Goods. Man-made objects, such as machinery and equipment, which are used in production. The income derived from capital goods is interest. Silicon Valley is home to 2,000 tech companies, the densest concentration in the world. This proximity to suppliers, customers, and cutting-edge research gives them a competitive advantage.
  3. Natural Resources. The raw goods and materials used by labor to create supply. The United States has a unique combination of easily accessible land and water. It has a moderate climate, miles of coastline, and lots of oil. The income from this is rent.
  4. Entrepreneurship. The drive of business owners to produce and innovate. The income from this is profits. America’s reliance on capitalism and a market economy supports a high level of entrepreneurship.

Summary Definition

Define Aggregate Supply: The aggregate supply is total amount of goods and services the market is willing to produce at a specific price as demonstrated on the aggregate supply curve.

  • The aggregate supply curve shows the amount of goods that can be produced at different price levels.
  • When the economy reaches its level of full capacity (full employment – when the economy is on the production possibility frontier) the aggregate supply curve becomes inelastic because, even at higher prices, firms cannot produce more in the short term
  • The aggregate supply curve is related to a production possibility frontier (PPF). Both show the productive capacity of an economy.

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