Aggregate Supply What is aggregate supply? Short run aggregate supply Long run aggregate supply

Aggregate supply definition and curve Price Level Aggregate supply is the total of all industry supply The aggregate supply curve shows total planned output in the economy at any given price level (average prices) In the short run, the aggregate supply curve (SRAS) is upward sloping The short run is defined as the period when the prices of factors of production are constant. In particular, money wage rates are fixed SRAS Real Output

SRAS upward sloping The SRAS is upward sloping because costs per unit rise as firms increase output in the short run to meet increased demand: They will ask existing staff to work longer hours, and will need to provide an incentive for them to do so – eg overtime (typically 1.5x normal wage rates) If demand remains strong they will seek to hire staff. Hiring is expensive and staff need to be trained, so costs increase Overall, we can say an increase in the price level acts as a signal to firms to produce more and; Firms will only produce more if the price level is higher

Movements and shifts Price Level SRAS Real Output P2 P1 P3 Y3 Y1 Y2 A movement along the aggregate supply curve happens when, all else equal, the price level changes. This will happen when the aggregate demand curve shifts! P1 P3 Real Output Y3 Y1 Y2

Movements and shifts Price Level SRAS2 SRAS1 SRAS3 Real Output P2 P1 The SRAS curve will shift when costs change: Wages rise or fall Raw material prices rise or fall Taxes (or subsidies) rise or fall Productivity increases or declines Price Level SRAS2 SRAS1 SRAS3 P2 P1 The SRAS curve will shift up from SRAS1 to SRAS2when costs increase (eg wage rates rise, raw material costs increase, taxes rise) The SRAS curve will shift down from SRAS1 to SRAS3 when costs fall (eg wage rates fall, raw material costs fall, taxes on firms are cut, or productivity improves) P3 Y1 Real Output

Shifts Why do changes in costs mean a shift in SRAS? For example, if wage rates are raised by 10%, firms’ costs of production will increase, and many will respond by raising prices, so the average price level will increase What about productivity? Productivity means output per unit of input. So labour productivity is output per worker (say per hour). With better technology, or a better educated worker, output per worker will increase. This means cost per unit will fall (same wages, more output) Any sneaky ones? How about a fall in the value of the pound – this means imported raw materials will be more expensive.

Movement or shift and why Government levies a tax on firms to pay for apprenticeships (Autumn Statement 2015) Stronger public finances means investors are more optimistic about the UK, and so the pound rises in value Unemployment falls to 5.4%, leading to faster growth in wages (and why would this happen?) Increased demand leads to an increase in the general price level The conflict in the Middle East leads to higher oil prices (and why would this happen) It is estimated that use of smartphones and tablets has raised productivity by 5% over the last year

Long run aggregate supply If demand increases, firms will supply more (as long as the average price level increases) Is there a limit to how much they can supply? In the long run, it doesn’t matter what the price level is, since firms will run into capacity constraints – workers cannot work overtime for too long, there may be no unemployed workers to hire, all machinery will be fully and efficiently utilised Therefore the long run aggregate supply must be fixed

Long run aggregate supply curve Price Level LRAS Real Output Yf

LRAS also means The LRAS curve is linked to or represents: Full capacity of the economy. Resources are fully and efficiently utilised It is possible to produce more than this for a period of time – eg workers working overtime, machinery not being maintained – but not in the long run! The PPF. The LRAS is the level of output shown on the PPF – where all resources are fully and efficiently utilised Trend growth (we will look at later)

SRAS to LRAS The vertical long run aggregate supply curve is often referred to as the Classical long run aggregate supply curve It is based on flexible prices particularly flexible wages, and the idea that markets always work to bring supply and demand into equilibrium This means that prices in all markets, including the labour market will adjust to bring supply and demand into equilibrium There can be unemployment in the short run, but this should lead to falling (real) wages, and so unemployment should only be temporary

SRAS to LRAS Price Level Real Output P Y Yf LRAS SRAS SRAS1 AD Let’s say we are at the equilibrium formed by AD = SRAS, so price level P and real output Y. This is less than full employment Yf which is the LRAS Price Level LRAS SRAS SRAS1 P AD Y Real Output Yf

SRAS to LRAS Price Level Real Output P Y Yf LRAS SRAS SRAS1 AD In the long run we assume the prices of factors of production (eg wages) are flexible, so since there is unemployment, there will be downward pressure on wages. This means firms costs will fall, which means SRAS shifts down, and we reach a long run equilibrium with full employment Price Level LRAS SRAS SRAS1 P AD Y Real Output Yf

Keynesian LRAS If the classical view was correct, unemployment should only be temporary Yet we can observe periods of mass unemployment, in the 1930s in many parts of the world, Greece and Spain today John Maynard Keynes wrote on how unemployment can persist in his book, ‘The General Theory of Employment, Interest and Money’ published in 1936 There are several reasons he believed unemployment can persist, but we look for the moment at just one: Wages are ‘sticky’, ie they do not fall – or do not fall sufficiently This may be because of laws such as minimum wages, unions, or legal protection, or because firms do not want to demotivate their workers This means SRAS will not shift down, and the short run equilibrium is in effect long run as well

Keynesian LRAS P1 P Y Yf Real Output This shows an equilibrium with unemployment. The only way to get rid of unemployment is therefore to increase aggregate demand, for example the government increasing spending eg on infrastructure Price Level LRAS P1 P AD1 Mass unemployment AD Y Yf Real Output

Keynesian LRAS and shifts in AD AD to AD1 there are plenty of resources, with mass unemployment, so firms can increase output without raising prices AD2 to AD3 resources become scarce, including labour, so wages and other costs increase, so firms raise prices AD4 to AD5 the economy is at full capacity which means increases in demand lead to higher prices and no increase in output (except in the short run) Price Level LRAS AD5 P AD4 Mass unemployment AD3 AD2 AD1 AD Yf Real Output

Shifts in LRAS 2.3.3 b)

Shifts in LRAS The LRAS will shift outwards if there is an increase in the quality or quantity of factors of production Better capital – technological advances Better quality machinery means an improvement in capital productivity (output per machine) so an increase in output Better labour – changes in education and skills Improvement in education and skills means workers should be more productive, so can produce more

Shifts in LRAS More capital – investment by firms As firms add to the capital stock, this will allow more production, so LRAS shifts out. Can be encouraged by government policy, such as lowering corporation tax, or reducing regulations More labour – demographics and migration LRAS can increase if the labour force increases Migration, eg from the EU. UK has seen 200,000+ a year net migration Increased participation in the workforce. Could happen with better childcare enabling more women to return to work after having children, and encouraging older workers not to retire Demographics actually working against increased labour force in many developed countries as the population ages

Shifts in LRAS – other points Government regulation Regulations can be a burden on business. Cutting regulations may therefore encourage businesses to invest and grow For example making it easier to set up a business encourages entrepreneurs to create companies, jobs and output, thus increasing LRAS Competition Government policies which encourage competition amongst firms can increase LRAS Competition forces firms to become more efficient (producing more and lowering costs) Competition encourages firms to innovate, introducing new products in order to beat competitors