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  • If an economy has considerable spare capacity, an increase in AS will increase productive capacity but will have no impact on output or the price level. This is illustrated in diagram 9.8

  • If the rise in productive capacity is caused by an increase in the labour force but the extra potential workers are not utilised, unemployment will rise.

  • Governments aim for sustained economic growth which requires AD and AS to increase in line with each other, as illustrated in diagram 9.9

Aggregate Supply

Long Run Aggregate Supply (LRAS)

Interaction Of Aggregate Demand & Supply

  • LRAS curve assumes that wage rates are variable, both upward and downwards. Classical or supply side economists assume that wage rates are flexible. Keynesian economists assume that wage rates may be ‘sticky downwards’ and hence the economy may operate at less than full employment even in the long run.

  • In the long run, there is a limit to how much firms can increase their supply. They run into capacity constraints. There is a limit to the amount of labour force that can be hired in an economy. Capital equipment is fixed in supply. Labour productivity has been maximised. So the LRAS curve is fixed at a given level of output, whatever the price level. So the LRAS curve is vertical on a diagram showing the price level and the real output.

  • The LRAS curve shows the productive potential of the economy. It shows how much real output can be produced over a period of time with the given level of factor inputs, such as labour and capital equipment, and a given level of efficiency in combining these factor inputs.

  • It can be linked to another economic concept

  • The LRAS curve is the level of output associated with production on the production possibility frontier of an economy. Any point on the boundary is one in which shows the level of real output shown by the LRAS curve.

  • The LRAS curve also shows the level of full capacity output in the economy. At full capacity, there are no under utilised resources in the economy. Production is at its long run maximum.
  • An increase in AD occurring when there is considerable spare capacity may have no effect on the price level but will increase the country’s output and employment. This is illustrated in diagram 9.4

  • An increase in AD which takes place when the economy is beginning to experience shortages of resources will result in a rise in output, the price level and employment. This is shown in diagram 9.5

  • When the economy is operating at full capacity, an increase in AD will be purely inflationary. It will increase the price level but have no effect on output and employment as illustrated in diagram 9.6

  • An increase in AS when an economy is initially producing at or close to full capacity would increase output and would put downward pressure on the price level as illustrated in diagram 9.7

Shifts In The LRAS Curve

  • The LRAS curve is likely to shift over time because the quantity and quality of resources changes over time, as does the way they are combined.

  • Causes in the shifts may be due to education and training which raises the skills of the workforce, investment in capital which raises the stock of physical capital and hence pushes the PP boundary, technological advances, increased world specialization through international trade which allows production to be located in the cheapest and most efficient place in the world economy, improved work practices such as just in time production which increases the productivity of both labour and capital and changes in government policy such as removal of unnecessary regulation which increases the efficiency of the firms.

  • A shift to the right in the LRAS curve shows that there has been economic growth. (On a PPF diagram, it would be represented by a movement outwards on the boundary)
  • A shift to the left in the LRAS curve would show that the productive potential of the economy has fallen(on a PPF diagram, this would be represented by a movement inwards)

  • The long run aggregate supply curve (LRAS) curve shows the relationship between aggregate supply and the price level when there has been time for the prices of output and resources to adjust fully to changes in the economy (Diagram 9.3 on page 77)

  • Monetarists/new classical economists argue that the LRAS curve is vertical. They think that, in the long run, the economy will operate at full capacity.

  • Keynesians argue that the economy can operate at any level of capacity in the long run. When there is considerable spare capacity in the economy, the LRAS curve may be perfectly elastic. This is because it will be possible for firms to employ more resources without raising average costs. As real GDP approaches the full employment level, aggregate supply becomes more inelastic. This is because firms start to experience shortages of resources which increase their price. When the economy reaches full capacity, aggregate supply becomes perfectly inelastic.

  • LRAS can increase as a result of an increase in the quantity and quality of resources. Specific reasons include immigration of workers, net investments, improved education and training, and advances in technology.

The Classical & The Keynesian LRAS

Short Run Aggregate Supply Curve (SRAS)

  • The vertical LRAS curve is called the classical long run aggregate supply curve.

  • It is based on the classical view that markets tend to correct themselves fairly quickly when they are pushed into disequilibrium by some shock. In the long run, product markets like the markets for oil, cameras and the factor markets like the market for labour, will be in equilibrium.

  • If all markets were in equilibrium, there can be no unemployed resources. Hence, the economy must be operating at full capacity on its production possibility boundary

  • The short run aggregate supply (SRAS) curve is drawn on the assumption that the prices of the factors of production (inputs or resources) remain unchanged. It slopes up from left to right because as output increases, average costs rise. This is because whilst the price of factors of production remain unchanged as more is produced, less efficient resources may be used and current workers may be paid overtime rates for additional output. In addition, when the price level rises, output prices usually rise relative to resource prices which increase producers’ profits.

  • The SRAS curve may shift to the left, if there is a rise in resource prices, a decrease in labour productivity, an increase in corporation taxes if there is a natural disaster.
  • Keynesian economists, however, point out that there have been times when the markets have failed to clear for long periods of time. They suggest that the LRAS curve is the shape shown in (diagram 8 on page 248 of green book)

  • At the output level of OB, the LRAS curve is vertical as with the classical LRAS curve. OB is the full capacity level of output of the economy. It is when the economy is one its production possibility boundary.

  • At an output level below OA, the economy is in deep and prolonged depression. There is mass unemployment. In theory, unemployment should lead to wages falling. If there is too much supply of labour, the price of labour will fall. However, in the modern economy, there are many reasons why wages are ‘sticky downwards’. There might be a national minimum wage which a floor for wages. Trade unions might fight to maintain wage levels. High unemployment might exist in one area of the country when there is full employment in another area because of labour immobility. Firms may not want to lower wages because it might demotivate staff and lead to lower productivity. So, at the output level below OA, markets, and in particular the labour markets fail to clear. Wages are stuck and there is persistent disequilibrium in the long run.

  • At an output level between OA and OB, labour is becoming scarce enough for an increase in demand for labour to push up wages. This then leads to a higher price level. The nearer output gets to OB, the full employment level of output, the greater the effect of an increase in demand for labour on wages and therefore the price level.

Shape & Determinant Of Aggregate Supply

  • Aggregate supply (AS) is the total supply that domestic producers are willing and able to sell at a given price level. It is the sum of all the industry supply curves in the economy. It shows how much output firms wish to supply at each level of prices.

  • In the short run the Aggregate supply curve is upward sloping.

  • The short run is defined as the period when money wage rates and the prices of all other factor inputs in the economy are fixed. If firms want to increase their output, they are unlikely to take on extra workers as it is an expensive process. Sacking them will lead to bad industrial relations within the company. So they will increase the output in the short run by working their existing labour force more intensively through overtime. Thus in the short term, an increase n the output will lead to an increase in their costs which in turn will result in some firms increasing prices. The increases in prices will be small because (given constant prices – wage rates for factor inputs, the increase in costs (wage earnings) are also likely to be fairly small.
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