Aggregate Supply

BIBLIOGRAPHY

Aggregate supply is an aggregate analogue of the concept of supply for individual goods and services markets that is used in microeconomic analysis. The aggregate supply of goods and services is usually taken to be related to the aggregate price level, a relationship that is called the aggregate supply function. The curve representing this relation is called the aggregate supply curve, and is a component of the popular aggregate demand–aggregate supply analysis of short-run macroeconomics, which abstracts from longer run issues such as capital accumulation and technological change.

The economist John Maynard Keynes defined the aggregate supply function as the relation between the level of employment and the aggregate supply price, which is the expectation of proceeds that makes it just worthwhile for firms to offer that level of employment, and distinguished it from the aggregate demand function that shows the relation between the proceeds that firms expect to receive and the level of employment. The modern use of aggregate supply and demand remains close to Keynes’s usage but replaces the relation between the value of output (or total proceeds) and employment to that between the price level and the quantity of output. Early economics textbooks after Keynes took the aggregate supply (AS) curve to be positively sloped like its microeconomic counterpart, but as shown in Figure 1, assumed it to be relatively flat at low levels of output, having an upward slope at intermediate levels, and to become increasingly steeper as the economy approaches full employment. At low levels of output many resources, including labor, are unutilized, and increases in output can be obtained without increases in input prices and without experiencing significant diminishing returns, so that firms are willing to produce more without any increase in the price. As output expands, diminishing returns sets in and input prices begin to rise, so that firms require a higher price to produce more. Finally, when full employment of labor is reached with the corresponding output level shown by Y_f in Figure 1, no further expansion in output is possible.

In subsequent (late twentieth-century) presentations this representation has been replaced by a variety of others, the relevance of which depend on the precise assumptions made about the economy and the time horizon one has in mind. The most popular representation, common to a number of Keynesian and monetarist approaches, takes the short-run aggregate supply curve to be positively sloped, as shown by the curve AS in Figure 2, and the long-run aggregate supply curve as vertical as shown by the vertical line at Y_n (denoting the natural level of employment, which is consistent with wage-price stability) in the figure. The short-run curve can extend beyond the long-run curve as shown in the figure, implying that

the economy can in fact produce beyond the level shown by the longer-run curve, for instance by hiring more workers than normal by paying overtime wages.

There are several interpretations of this configuration. One interpretation—common among the neoclassical synthesis Keynesians—assumes that firms operate in a perfectly competitive market and with diminishing returns to labor. With the money wage given in the short run, a higher price makes profit-maximizing firms increase employment and production. With the money wage flexible in the longer run, the money wage changes; if there is unemployment, the money wage falls, so that the aggregate supply curve shifts down. In the long run the economy is at full employment, where the demand for labor and the supply of labor (both of which depend on the real wage) are equal, so that the economy is at Y_n in the figure. A second interpretation—made by the early monetarists—takes the price level expected by workers to be given, but allows the money wage to adjust to clear the labor market, in the short run. A higher price increases the money wage as firms increase their demand for workers, and workers supply more labor because with the fixed expected price their expected real wage is higher. Over the longer run the expected price adapts to the actual price, which shifts the AS curve; in long run equilibrium price expectations are fulfilled and the economy is at Y_n. A similar interpretation—often made by new Keynesians—assumes that the money wage depends on the expected price and on labor market conditions reflected by the unemployment rate, and that the price level is determined by firms as a markup on unit labor costs. In the short run, with expected price given, a higher level of output implies a lower unemployment rate, a higher money wage and a higher price. In the longer run, as expected price adapts to the actual price, the AS curve moves; for instance, if the economy produces below Y_n, the expected price falls, so that the AS curve shifts down. The long-run supply curve is given at the natural rate of unemployment at which the wage and price are stable, as determined by labor market conditions and the pricing policies of firms. Unemployment may prevail due to, for instance, firms keeping wages higher than the market, clearing one to make workers exert more effort, thereby becoming more productive.

In all of these interpretations, in the short run the economy is on the AS curve, at a position determined by the AS curve and the downward-sloping aggregate demand (AD) curve. Since the short-run position of the economy is not at Y_n, the price and wage will change; at the intersection shown in Figure 2, the price and wage falls so that AS shifts down, and the economy moves along the AD curve until long-run equilibrium is attained at Y_n, so that the vertical line can be given the interpretation of the long-run AS curve. This adjustment occurs because (as is shown by the negative slope of the AD curve) a reduction in the price reduces the demand for money (since less money is required to make transactions), which makes asset holders want to lend more thereby reducing the interest rate and inducing more spending. The nature of the short-run and long-run aggregate supply curves, given by AS and Y_n, implies that changes in the aggregate demand curve (such as fiscal and monetary policy shifts, or changes in expectations which affect investment) have an effect on output in the short run, but not in the long run.

This interpretation, however, is not accepted by all approaches. Some take the view that the economy is always on the vertical curve, so that it is the only AS curve for the economy. These views, which are associated with the new classical approach, assume that the money wage is perfectly flexible (in contrast to the neoclassical Keynesians) and that economic agents have rational expectations (in contrast to the early monetarists) and do not make systematic forecasting errors, so that it is inappropriate to take the expected price as given in the short run. In this approach, the AS curve is the vertical curve at full employment, so that aggregate demand shifts do not affect the level of output. However, this result need not hold if there are wealth effects on labor supply. With the traditional interpretation based on the supply and demand for labor and market clearing wage, a change in the price level can affect the value of real wealth, which in turn can affect the supply of labor and the level of employment.

Approaches having the rising short-run AS curve need not accept the interpretation that vertical curve is the long-run AS curve. First, the economy may not converge to Y_n, so that the vertical line cannot be given the interpretation of the long-run supply curve. For instance, if the economy is below Y_n in the short run, the downward shift in the AS curve need not take the economy to Y_n if the AD curve also shifts to the left or because it is not negatively sloped if, for instance, as the money wage falls aggregate demand falls as wage income falls (with a higher propensity to spend out of wage than out of profit income) or because firms reduce investment when the price falls. Second, even if the economy converges toward Y_n, its level may change endogenously, so that the longrun supply curve need not be vertical. For instance, according to some new Keynesian contributions, a fall in output and employment below the natural rate can make outsiders in the labor market lose their ability to reduce the wage, which increases the natural rate of unemployment and reduce Y_n. In these cases the aggregate supply side of the story implies that the aggregate demand side can have effects not only in the short run, but also in the longer run.

SEE ALSO Aggregate Demand; Economics, Keynesian; Economics, New Classical; Keynes, John Maynard; Lucas, Robert E.; Macroeconomics

BIBLIOGRAPHY

Dutt, Amitava Krishna. 2002. Aggregate Demand-Aggregate Supply Analysis: A History. History of Political Economy 34 (2): 321-363.

Keynes, John Maynard. 1936. The General Theory of Employment, Interest and Money. London: Macmillan.

Tarshis, Lori. 1947. The Elements of Economics: An Introduction to the Theory of Price and Employment. Boston: Houghton-Mifflin.

Amitava Krishna Dutt

Aggregate Supply

What It Means

Aggregate supply, along with its complementary concept, aggregate demand, is a term used in macroeconomics (the study of the economy as a whole, as opposed to microeconomics, which concerns the individual parts of an economy). It refers to the supply, or quantity, of all “final products” in an economy. Final products are the economy’s finished products, such as cars or a loaf of bread, not the raw materials or “intermediate products,” such as steel or wheat, that are converted into other products. These finished products might be sold to consumers, businesses, or governments.

Prices also play a role in the concept of aggregate supply. The amount of final goods and services that sellers in an economy are willing and able to produce is influenced by the prices they can charge. In general, the higher the prices, the more sellers will produce. In discussing aggregate supply, economists use the average price for all final goods and services in an economy, not the price of any particular product. Aggregate demand is commonly defined, in fact, as the amount of final products sellers are willing to produce at a given average price.

The macroeconomic concepts of aggregate supply and aggregate demand are based on the microeconomic concepts of supply and demand. Supply is the quantity of a good or service that a business is willing to sell at a given price, and demand is the quantity of a good or service that consumers are willing to buy at a given price. As prices rise, supply increases, and demand decreases. Aggregate supply and aggregate demand follow the same pattern.

Aggregate supply is commonly represented using diagrams called aggregate supply, or AS, curves. There are two different AS curves, the short run aggregate supply curve (SRAS curve) and the long run aggregate supply curve (LRAS curve). The short run and the long run refer not to specific time periods, such as one month or one year; rather, they describe undefined time periods, one shorter than the other, during which businesses have different options open to them. In the short run a business can increase profits by making some changes, but it cannot alter other aspects of its operations. In the long run a business can make adjustments to all aspects of its operations.

The two AS curves are shaped differently to reflect different conditions of doing business over time. With price level on the vertical axis and output, or production, on the horizontal axis, the SRAS curve slopes upward from left to right, indicating that in the short run, aggregate supply rises as the price level rises and falls as the price level falls. In other words, businesses produce more when prices are higher. The LRAS curve, by contrast, is vertical, indicating that in the long run, price levels have no effect on aggregate supply. Aggregate supply curves, together with the aggregate demand curves, are useful tools for understanding and predicting the behavior of the economy under a variety of different conditions.

When Did It Begin

The concept of aggregate supply, like that of aggregate demand, came into being as a part of the so-called Keynesian Revolution in economics. This radical reshaping of the field of economics was named after its instigator, the British economist John Maynard Keynes, whose book The General Theory of Employment, Interest, and Money (1936) offered solutions to the Great Depression, the severe economic crisis that afflicted the world economy in the 1930s. Keynes showed that the principles of supply and demand could be extended beyond individual markets and applied to the economy as a whole. He introduced the concepts of aggregate supply and aggregate demand, the grand totals of goods supplied and demanded in an entire economy. Likewise, Keynes showed, these grand totals could be observed in relation to average prices across the economy. Viewing the economy in this top-down, big-picture way would, in turn, allow governments to better regulate their economies.

Keynes thus laid the foundations for what we now call macroeconomics and to the division of all economic study into its macro and micro branches. The concepts of aggregate supply and aggregate demand as he outlined them are still at the foundation of all macroeconomic theory.

More Detailed Information

As the price level in the economy rises, so does aggregate supply. This occurs because rising prices mean that the difference between producers’ costs (such as the cost of paying wages, the cost of equipment, the cost of land, and the cost of electricity) and producers’ revenue (the total value of sales) widens. This difference between cost and revenue is profit. The greater the potential for profit in the economy, the more goods and services sellers will supply.

At any given time some producers’ costs are fixed: they are either impossible to alter or unlikely to be altered. For example, employers often enter into contracts with their workers specifying their rate of pay for a period of a year or more. This means that if the price level falls, sellers cannot simply adjust their costs; some of those costs, such as labor, cannot be changed right away. Even if workers are not covered by contracts, employers may be hesitant to reduce wages as soon as the price level drops, because they may fear angering their employees. Likewise, if prices are rising, employers may not leap to adjust wages and salaries upward for fear of making workers believe that they can expect regular pay increases in the future.

The period of time during which some costs are fixed is the short run. The short run could be one day, or it could be two years. During a prolonged period of economic stagnation, for example, employers will renegotiate contracts or cut wages regardless of the effect this has on worker morale. This change would mark the moment when the short run gives way to the long run. The long run begins at the point when fixed costs become flexible. In the long run, all costs are flexible.

The existence of fixed costs in the short run explains the different shapes of the two AS curves. In the short run, as the price level rises but some seller costs remain fixed, sellers will increase supply in response to growing levels of profit. Under opposite conditions, a falling price level would result in diminished profits for sellers, who would respond by cutting back on production. Thus, the SRAS curve is upward sloping, indicating a steady rise in aggregate supply as the price level rises or, in the other direction, a steady decline in aggregate supply as the price level falls.

In the long run, however, since employers can alter all costs, supply is not affected by changes in the price level. If prices fall over the long run, for example, sellers can alter any and all of their costs, including their labor costs, to keep their profit levels constant. Long-run aggregate supply is equal to the potential output of all sellers, which is dependent only on society’s resources (such as land and natural resources, the size and characteristics of the labor force, and the amount and variety of equipment available for production). The LRAS curve is, accordingly, a vertical line.

Both the SRAS curve and the LRAS curve can shift (that is, the entire curve moves to the left or the right on the diagram). A shift in the SRAS curve indicates that aggregate supply has either increased or decreased independently of the price level. Shifts occur because there are factors other than the price level that can affect a company’s level of profits. When these factors change, the curve shifts to the left (indicating decreased aggregate supply) or to the right (indicating increased aggregate supply).

One development that can cause shifts in the SRAS curve is a change in production costs. For example, when the price of oil increases dramatically because of tensions in the Middle East (where much of the world’s oil comes from), the cost of producing goods rises for sellers across the economy, since many industries are highly dependent on oil-based fuels. This development would cut into profits, and if businesses responded by cutting production, the SRAS curve would shift to the left. A decline in the price of oil could trigger the reverse phenomenon: increased profits for sellers, leading to increased production and a rightward shift of the SRAS curve.

Another factor that could result in a shift of the SRAS curve is an unexpected change in wages. Many employers pay workers not only in dollar amounts specified by contracts but also in benefits such as health insurance. If insurance companies raise premiums dramatically from one year to the next, sellers who provide insurance for their employees will absorb this cost and, in turn, possibly cut back on production. This would be represented by a leftward shift of the SRAS curve. A decline in the costs of health insurance could result in a rightward shift of the curve.

Increases or decreases in workers’ productivity can also cause the SRAS curve to shift. For example, new computer programs that allow companies to keep accurate tabs on their operations across great geographical distances might speed up production and eliminate costly errors. This would result in lower production costs, which would increase profits and spur companies to increase supply. A rightward shift on the SRAS curve would illustrate this development. Worker productivity could, on the other hand, be hampered by new government regulations requiring increased paperwork. If the paperwork slowed down the production process across the economy, its effect would appear as a leftward shift of the SRAS curve.

The LRAS curve can also shift, in connection with increases or decreases in a society’s resources. The potential output of the U.S. economy has grown consistently over the country’s history, reflecting a growing and increasingly skilled workforce, technological progress, and other developments that increase potential production. The LRAS curve for the U.S. economy has thus shifted regularly to the right (the rate at which the LRAS curve shifts to the right measures long run economic growth). On the other hand, a country whose population is decimated by a natural disaster or war would experience a dramatic decrease in potential production. This would be represented by a shift of the LRAS to the left.

Recent Trends

The study of economics has been directly shaped by the major economic crises of the twentieth century. The Great Depression stumped economists who believed in the self-regulating ability of the market system. In the United States and other countries, up to 25 percent of workers lost their jobs and had no ability to buy the products that the country’s numerous state-of-the-art factories could produce. Businesses therefore shuttered their factories or dramatically scaled back production. John Maynard Keynes revolutionized economics by showing that governments could effectively stimulate aggregate demand (the quantity of goods buyers across the economy were willing to buy) by spending money in a variety of ways. Keynes’s theories led to recovery from the Depression and were thus adopted as the authoritative word on economic regulation.

In 1979, however, the U.S. economy experienced its most drastic crisis since the Depression because of events that affected aggregate supply rather than aggregate demand. A revolution in Iran, one of the world’s largest oil producers, led to oil shortages and fears of further instability in the region, which sent the worldwide price of oil soaring. Since so many businesses are heavily dependent on oil-based fuels, high oil prices meant increased production costs across the economy; this translated into decreased aggregate supply. A Keynesian approach to the crisis—managing aggregate demand—offered no solutions, since demand was not the problem.

As a result, another evolution of economic thought occurred. The 1979–80 crisis helped economists understand that some recessions (periods of economic stagnation) could be caused by demand shocks (as with the Great Depression, a particularly severe recession), while others could be caused by supply shocks.

AGGREGATE SUPPLY

Aggregate supply is the total amount of goods and services that U.S. businesses are prepared to produce for sale to buyers at various price levels. When the demand for businesses' products increases, the prices they charge for those products tend to rise. Businesses will then increase the supply of those goods. When the prices for goods and services fall, aggregate supply also tends to fall.

With a constantly growing U.S. population the demand for goods and services generally rises over time. Aggregate supply rises to meet that demand. But aggregate supply is affected by more than just prices and demand. The number of businesses competing in a market, the effects of technology on worker productivity, the costs of paying workers or buying raw materials, and even the weather can affect the total amount of goods and services businesses produce for sale. For example, a drought can destroy wheat farmers' crops, lowering the supply of wheat they can bring to market. The federal government can stimulate the growth of aggregate supply by spending less than it takes in taxes. This frees up money to be invested in opening new businesses and factories. The government can also implement tax policies that reward businesses and individuals for investing, or that lower the costs of doing business.

In 1929 the wealth of many consumers and businesses was wiped out by a stock market crash. The United States experienced the worst drop in aggregate supply in its history. This process resulted in the Great Depression. Demand for goods and services fell, prices dropped, and businesses cut back the production of goods because they could not make a profit on them. All these events were the result of consumers and businesses having less money to spend on goods and services. After World War II aggregate supply skyrocketed. According to some economists, this happened because the federal government's huge spending on the war effort had resulted in surplus wealth among consumers and businesses. Businesses increased aggregate supply to meet this new demand. During the energy crises of the 1970s U.S. aggregate supply fell because the rising price of oil increased the costs to businesses of producing goods and services.

See also: OPEC Oil Embargo, Stock Market Crash