NIPD - Aggregate Supply Lesson

Aggregate Supply

Introduction

In economics, aggregate supply is the total supply of goods and services that firms in a national economy plan to sell during a specific time period. It is the total amount of goods and services that the firms are willing to sell at a given price level in the economy.

Aggregate supply is the relationship between the price level and the production of the economy.

Firms make decisions about what quantity to supply based on the profits they expect to earn. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs, like labor or raw materials, the firm needs to buy. Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce and sell. The aggregate supply (AS) curve shows the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level.

Watch the video below to get an overall idea of aggregate supply.

 

 

Aggregate Supply

Aggregate Supply: the total quantity of goods & services produced by all sellers at various prices, assuming that factor prices remain constant.
This means, in the short term, wages and prices of raw materials and of other resources are all also assumed to remain unchanged. This is not a totally un-realisitc assumption. Most firms have little control over the market demand for their products; what they can do is control their own supply as much as they can as well as their present and future costs. Firms can control costs by getting into contracts with their suppliers and with their employees (or their unions) to achieve a little certainty
of future resource prices and wage rates. With these contracts, the firm is able to increase production (and demand, which will employ more factor services) without having to deal with an increase in the costs of those resources. With an increase in demand, firms can sell their products at a higher price which also results in wanting to produce more (employ more resources). Their total profits will be much higher as their costs still remain low.
The higher the price levels, the higher the aggregate quantity supplied will be; the lower the price level, the lower the aggregate quantity supplied will be.
The aggregate supply curve is upward-sloping and is very unlikely to be a straight line. 

Determinants of Aggregate Supply

• Improvement in human capital
• increase in the amount of capital (natural resources)
• improved technology
• Quantity and Quality of Labor (Improved)

* If potential GDP increases, aggregate supply will also increase.

An increase in any of the determinants will shift the aggregate supply curve to the right which will equally shift potential GDP (economic growth). A decrease in any of the determinants will shift the aggregate supply curve to the left. (An increase in aggregate supply, leads to a higher real GDP but lower prices).

The model of aggregate demand and long-run aggregate supply predicts that the economy will eventually move toward its potential output. To see how nominal wage and price stickiness can cause real GDP to be either above or below potential in the short run, consider the response of the economy to a change in aggregate demand.

Look at the graph below - it shows an economy that has been operating at potential output of $12,000 billion and a price level of 1.14.

 

This occurs at the intersection of AD₁ with the long-run aggregate supply curve at point B. Now suppose that the aggregate demand curve shifts to the right (to AD₂). This could occur as a result of an increase in exports. (The shift from AD₁ to AD₂ includes the multiplied effect of the increase in exports.) At the price level of 1.14, there is now excess demand and pressure on prices to rise. If all prices in the economy adjusted quickly, the economy would quickly settle at potential output of $12,000 billion, but at a higher price level (1.18 in this case).

Is it possible to expand output above potential? Yes.

It may be the case, for example, that some people who were in the labor force but were frictionally or structurally unemployed find work because of the ease of getting jobs at the going nominal wage in such an environment. The result is an economy operating at point A (in the graph above) at a higher price level and with output temporarily above potential.

Consider next the effect of a reduction in aggregate demand (to AD₃), possibly due to a reduction in investment. As the price level starts to fall, output also falls. The economy finds itself at a price level–output combination at which real GDP is below potential, at point C. Again, price stickiness is to blame. The prices firms receive are falling with the reduction in demand. Without corresponding reductions in nominal wages, there will be an increase in the real wage. Firms will employ less labor and produce less output.

By examining what happens as aggregate demand shifts over a period when price adjustment is incomplete, we can trace out the short-run aggregate supply curve by drawing a line through points A, B, and C. The short-run aggregate supply (SRAS) curve is a graphical representation of the relationship between production and the price level in the short run. Among the factors held constant in drawing a short-run aggregate supply curve are the capital stock, the stock of natural resources, the level of technology, and the prices of factors of production. A change in the price level produces a change in the aggregate quantity of goods and services supplied and is illustrated by the movement along the short-run aggregate supply curve. This occurs between points A, B, and C in the graph.

Reasons for Wage & Price Stickiness

Learn more about Wage and Price stickiness in the activity below.

 

Watch the presentation below to learn more about aggregate supply.

 

Firms make decisions about what quantity to supply based on the profits they expect to earn. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs—like labor or raw materials—the firm needs to buy. Aggregate supply, or AS, refers to the total quantity of output—in other words, real GDP—firms will produce and sell. The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level.

Watch the video below to learn how this all works together.

 

 

Review

Review what you have learned by completing the activity below.

In Summary . . .

The short run in macroeconomics is a period in which wages and some other prices are sticky. The long run is a period in which full wage and price flexibility, and market adjustment, has been achieved, so that the economy is at the natural level of employment and potential output.

The long-run aggregate supply curve is a vertical line at the potential level of output. The intersection of the economy’s aggregate demand and long-run aggregate supply curves determines its equilibrium real GDP and price level in the long run.

The short-run aggregate supply curve is an upward-sloping curve that shows the quantity of total output that will be produced at each price level in the short run. Wage and price stickiness account for the short-run aggregate supply curve’s upward slope.

Changes in prices of factors of production shift the short-run aggregate supply curve. In addition, changes in the capital stock, the stock of natural resources, and the level of technology can also cause the short-run aggregate supply curve to shift.

In the short run, the equilibrium price level and the equilibrium level of total output are determined by the intersection of the aggregate demand and the short-run aggregate supply curves. In the short run, output can be either below or above potential output.

 

IMAGES CREATED BY GAVS