Determinants of Aggregate Supply
Definition
Aggregate supply (AS): the total real output firms in an economy are willing and able to produce at each average price level.
Short-run AS (SRAS): output supplied while factor prices are fixed, so it is driven by production costs.
Long-run AS (LRAS): output supplied once factor prices adjust, set by the quantity and quality of resources.
- Short-run aggregate supply shifts when firms' costs of production change.
- Long-run aggregate supply shifts when the quantity or quality of resources changes.
- Naming the correct determinant tells you whether SRAS or LRAS moves.
Key Idea
- SRAS is driven by costs such as wages and energy prices.
- LRAS is driven by the quantity and quality of factors of production.
Short-Run Determinants
- Money wage rates: higher wages raise costs at each output, shifting SRAS left.
- Raw material and energy prices: dearer inputs such as oil raise costs and shift SRAS left.
- Indirect taxes and subsidies: a higher production tax shifts SRAS left, while a subsidy shifts it right.
Example
- Suppose the oil price jumps from $70 to $100 a barrel, and oil is a key input across the economy.
- A factory's annual energy bill rises from £50,000 to £70,000, so costs climb at every level of output.
- At each average price level firms are now willing to supply less real output.
- The SRAS curve shifts left, from SRAS1 to SRAS2.
- The result is a higher average price level and lower real output, known as cost-push inflation.
Long-Run Determinants
- The quantity of factors: more labour, capital and land raises potential output, shifting LRAS right.
- The quality of factors: education, training and technology lift productivity, shifting LRAS right.
- Investment in new capital: expands the economy's productive capacity, shifting LRAS right.
Example
- Suppose firms invest £20bn in new machinery and infrastructure over several years.
- The economy gains more and better capital, raising output per worker.
- The maximum output the economy can produce at full employment rises.
- The LRAS curve shifts right, from LRAS1 to LRAS2.
- This represents long-run, or potential, economic growth.
Note
- Label the macro axes as the average price level and real output, not price and quantity.
- A short-run change affects costs, while a long-run change affects capacity.
Why the Distinction Matters
- Short-run cost changes shift SRAS and can be reversed if the shock unwinds.
- Long-run capacity changes shift LRAS and are more lasting.
- Only a rightward LRAS shift raises an economy's trend rate of growth.
- Whether an SRAS shift proves temporary depends on the trigger: a one-off oil spike may reverse, but a permanent wage rise will not.
Exam technique
- State whether a change affects short-run or long-run aggregate supply.
- Show the shift in the correct direction and label the new curve.
- Link a rightward long-run shift to trend growth.
Common Mistake
- Do not confuse a cost change, which shifts SRAS, with a capacity change, which shifts LRAS.
- Do not label the macro axes price and quantity; use average price level and real output.
Self review
- What determines short-run aggregate supply?
- What determines long-run aggregate supply?
- How does a rise in oil prices affect SRAS?
- Which shift raises an economy's trend growth?
