Aggregate supply
Author
Institution
Aggregate supply is a measure of the volume of commodities and services that an economy has a capacity to produce at a certain price level. The short run aggregate supply curve depicts the amount of output that an economy is capable of producing in the short term at various price levels. The short run aggregate supply curve is upward sloping because input prices tend to adjust at a slower rate than that of the final goods; this leads to higher profit, which makes firms to increase production. Besides, the short run aggregate supply curve is upward sloping since some firms tend to adjust prices at a slower rate than others (Mankiw, 2008). This makes such firms think their sales are increasing and thus increase their production. On the other hand, the long run aggregate supply curve depicts the volume of commodities and services produced by an economy in the long term in relation to different price levels. Unlike the short run aggregate supply curve, the long run aggregate supply curve slopes vertically rather than sloping upwards. In this assignment, short run aggregate supply curve and long run aggregate supply curves together with variables that move them will be discussed. In addition, the macroeconomic equilibrium in the long run and short run will also be discussed.
The short run aggregate supply curve shows a relationship between the volume of commodities and services and price levels that an economy is capable of producing, in the short term. This curve is upward sloping; as the price level rises, firms increase the quantity of commodities and services supplied. Alternatively, as the level of price drops, firms tend to decrease the volume of commodities and services supplied (Mankiw & Taylor, 2006).
Reasons Why the Short Run Aggregate Supply Curve is Upward Sloping
One of the reasons why the short run aggregate supply curve is upward sloping is because of sticky wages. Some economists have a perspective that wages are inflexible, or sticky. This is based on the opinion that wages become locked in for some years because of the labor contracts entered into by employees and management. For instance, the management and labor may reach an agreement of locking in wages for the following one to three years because they may see this as being for their best interest. The management has an idea regarding the cost of labor during the period of the contract while; on the other hand, workers have a sense of security since they know that their wages will not become lowered during the contract period. Besides, wages may also become sticky because of perceived notions of fairness or certain social conventions. When there is a change in the economy, the wages paid to workers, do not adjust immediately because of the contract that exists (Mankiw, 2008). So, when price level increases, the nominal wage remains fixed while the real wage falls since the real wage is based on the purchasing power associated with the wage. A fall in the real wage implies that labor becomes relatively cheaper than before. Firms choose to hire more workers, when labor becomes cheaper which increases their level of production. Therefore, when there is an increase in the price level, output increases due to sticky wages.
Another reason for the upward sloping nature of the short run aggregate supply curve is because of worker mis-perception. The amount of work that a worker wills to supply is usually based on the real wage that is expected; the workers are always willing to supply more work at a higher real wage. So, when the price level increases, there is an assumption that firms have more information than workers, which will lead to firms increasing the nominal wage. However, because workers are not aware whether the price level increased, they believe that their real wage has also increased. Workers tend to work more, when they believe their real wage has increased, which leads to an increase in production. Therefore, an increase in price, increases the level of output because of worker mis-perception.
Imperfect information is another explanation for the upward sloping nature of the short run aggregate supply curve. When there is an increase in the level of price, producers take it for a relative price level increase (Mankiw, 2008). The real wage earned by the producers rises as relative price increases; this makes producers to supply more labor leading to an increase in the output produced.
Variables That Move The Short Run Aggregate Supply Curve
Expected Changes in the Future Price Level
The short run aggregate supply curve shifts in order to reflect firm and worker expectations of future prices. When workers and firms expect the price level to increase, they adjust their wages by the same amount that the price increases. Keeping all other variables that affect the aggregate supply, the short run aggregate supply curve shifts to the left when the future price levels are expected to rise. A graphical representation of this is as illustrated.
Price LevelSRAS2
SRAS1
P2
P1
Output
When the price level is expected to rise from P1 to P2, the short run aggregate supply curve shifts to the left from SRAS1 to SRAS2.
Capital Stock or Labor Force
An increase in the capital stock or labor force implies that firms are capable of producing more output at each price level (Mankiw & Taylor, 2006). Therefore, an increase in the capital stock or labor force will shift the short run aggregate supply to the right as illustrated; the short run aggregate supply curve will shift from SRAS1 to SRAS2.
Price level SRAS1
SRAS2
Output
Productivity
The quantity of output produced determines the cost utilized in producing an output; the lower the productivity, the higher the cost of producing the output and the converse is true. Therefore, an increase in productivity will shift the short run aggregate to the right since it will lower the cost of producing the output. The illustration is as shown; the short run aggregate supply curve will shift from SRAS1 to SRAS2.
Price level
SRAS1 SRAS2
Output
Expected Price of a Vital Natural Resources
The price of producing a certain output is based on the cost of the input. When the price of an input increases, the cost of producing an output also increases. Therefore, when the cost of a vital natural resource is projected to rise, firms are likely to increase the price level of the output; this will have an effect of shifting the short run aggregate supply curve to the left since the cost of producing an output is also expected to rise. Therefore, if the price of a vital natural resource is expected to rise, the short run aggregate supply curve will shift from SRAS1 to SRAS2 as depicted in the illustration.
SRAS2 SRAS2
Price level
Output
The Long Run Aggregate Supply Curve
The long run aggregate supply curve shows the level of real output at every possible price level. The long run aggregate supply curve is vertical in nature since, in the long run, prices of resources have already adjusted to the price changes, which implies that there is no room left for incentive for firms in the long run to change their output. Therefore, price is assumed to have fully adjusted in the long run and thus the price has no effect on the volume of output produced.
Variables That Move the Long Run Aggregate Supply Curve
Any change in the economy, which alters the natural rate of output is deemed to shift the long run aggregate supply curve. Shifts of the long run aggregate supply curve is deemed to be caused by the following variables; capital, labor, technological knowledge and natural resources.
Labor
An increase in labor implies that there is an increase in output. For instance, an increase in the number of workers leads to an increase in output since the workforce increases. An increase in output causes a shift in the long run aggregate supply curve to the right. Alternatively, a decrease in labor implies a decrease in the workforce which leads to a decrease in output. The decrease in output causes a shift in the long run aggregate supply curve to the left. The following illustrations show a graphical representation of increase and decrease of labor.
Increase of Labor
Price Level LRAS1 LRAS2
Output
An increase in labor leads to an increase in output, which forces the long run aggregate supply curve to shift from LRAS1 to LRAS2.
Decrease in Labor
A decrease in labor leads to a reduction in the volume of output, which shifts the long run aggregate supply from L1 to L2 as follows;
Price Level L2 L1
Output
Capital
An increase in capital stock in an economy increases productivity, and thus the volume of commodities and services supplied. As a result of the increase in the volume of output, the long run aggregate supply curve shifts to the right. On the other hand, a decrease in the capital stock, in an economy, leads to a reduction in productivity that causes a reduction in the volume of output. The reduction in output makes the long run aggregate supply curve to shift to the left. A graphical representation of the effect of capital is as depicted in the following illustrations.
Increase in Capital
As a result of an increase in capital, output increases leading to a shift in the long run aggregate supply curve from LRAS1 to LRAS2 as illustrated.
Price Level LRAS1 LRAS2
Output
Decrease in Capital
A decrease in capital causes a reduction in productivity, which implies that there is a decrease in output. The decrease in output makes the long run aggregate supply curve from LRAS1 to LRAS2 as shown.
Price Level LRAS2 LRAS1
Output
Natural Resources
The production of an economy usually depends on the available natural resources, which include minerals, weather and land. Discovery of new minerals shifts the long run aggregate supply curve to the right as a result of increase in output. Besides, a change in weather that favors farming practices increases output leading to a shift in the long run aggregate supply curve to the right. The following is a graphical representation of the effect of a new discovery of a vital natural resource.
Price Level LRAS1 LRAS2
Output
The discovery of a new vital resource in an economy increases productivity, which leads to an increase in the volume of output. An increase in output makes the long run aggregate supply curve shift from LRAS1 to LRAS2.
Technological Knowledge
Growth in technology is positively related to increase in production. For instance, the invention of the computer has aided in increasing the output. Therefore, the adoption of emerging technologies will lead to increased output, which shift the long run aggregate supply curve to the right. The following graphical illustration is a representation of the effect of technology on the long run aggregate supply curve; the long run aggregate supply curve shifts from LRAS1 to LRAS2.
Price Level LRAS1 LRAS2
Output
Macroeconomic Equilibrium in the Short Run and Long Run
An unanticipated decrease in aggregate demand, in the short run, will cause an excess supply of resources that will cause a decline in the price of resources. Unemployment is likely to increase as prices go down and output will decline. Over a long period, lower resource costs will lead to shifting of the aggregate supply to the right (Stonecash, 2011). The economy will produce a level of output consistent with the full employment, but at lower price levels. On the other hand, an unanticipated increase in the aggregate demand, in the short run, will lead to a level of output, which is greater than a level consistent with the full employment. This is because the price levels tend to be different from the levels anticipated by providers of resources. In this case, the unemployment will be less than the natural rate. Besides, there will be an upward pressure on interest rates and price of resources, which will lead to a decrease in the aggregate demand in the long run. Providers of resources are likely to make adjustments to new price levels and output will decline to match a level consistent with the full employment. A fresh market equilibrium will become established at a higher price level. Hence, in the long run, higher prices (inflation) will become the chief effect of the increase in the aggregate demand.
A decrease in the short run aggregate supply, in the short run, will decrease the availability of resources. This will cause an increase in the price of resources, which will lead to the shifting of the aggregate supply curve of commodities and services to the left. A decreased output level will be produced at soaring prices. In case the cause of the decrease in short run aggregate supply is temporal, then there will be no changes in output or prices in the long run (Stonecash, 2011). However, if the cause is more vital, then the long run supply curve is likely to shift to the left. In such a case, the economy will produce few commodities and services at higher prices. In the short run, an increase in the aggregate supply will lead to shifting to the right of the short run aggregate supply. Income and output will expand beyond a level consistent with the full employment at lower price levels. In case what produced an increase in aggregate supply is temporal, the short run aggregate supply curve will return to the normal levels while the output and prices will remain as before. In case what caused the change is permanent, both the long run aggregate supply curve and the short run aggregate supply curve will shift to the right. There will also be a greater volume of output at lower prices (Stonecash, 2011). Therefore, a decrease in the aggregate demand, in the short run, causes a recession while it causes a decrease in the price level, in the long run.
Conclusion
The short run aggregate supply curve shows the volume of output, which an economy is capable of producing in the short term at various price levels. The curve is upward sloping because input prices correct at a slower rate than that of the final goods; this leads to a higher profit, which makes firms to increase output. Besides, the short run aggregate supply curve is upward sloping because some firms tend to adjust prices at a slower rate than others. The long run aggregate supply curve shows a relation of output at specific price levels. This curve is vertical in nature since the prices have already adjusted. While price level has an effect on the short run aggregate supply curve, prices have no effect on the long run aggregate supply curve. Therefore, a shift in the long run is caused by other variables other than the price, which include, technology, capital stock, labor, and new discoveries of vital natural resources.
References
Stonecash, R. E. (2011). Principles of macroeconomics. South Melbourne, Vic: Cengage Learning.
Mankiw, N. G., & Taylor, M. P. (2006). Economics. London: Thomson.
Mankiw, N. G. (2008). Essentials of economics. Mason, OH: South-Western Cengage Learning.
