Aggregate supply

AGGREGATE SUPPLY – WHAT DOES THE TERM MEAN?

Known as total output, aggregate supply can be summed up as the total supply of goods and services produced by the economy of a country at a given price during a given span of time. When we talk about the supply of a nation, it is the aggregate supply of the country that we are talking about. It is represented by the aggregate supply curve that shows the relationship between the price and the quantity of output that companies are willing to supply at each price level. There are two types of aggregate supply depending on the period it is calculated on. They are – short-run aggregate supply and long-run aggregate supply.

The long-run aggregate supply of a nation is affected by four factors. They are: 

1. Labor

The value of labour depends mostly on the education and the skill set of the workers who create the products and services that are supplied. The remuneration for the labour provided is in the form of wages. The more skilled the labour, the higher is the aggregate supply of the country. This is because only a skilled labour force can adapt and act according to the changing demand of the consumers.

2. Capital Goods

The types of machinery and equipment that are used in production are known as capital goods. The better the technological advancements of a country, the higher will be its aggregate supply. What wages are to labour, interest is to the income derived from capital goods. A country like the USA has the highest aggregate supply in the world because of the various advanced technologies that they use. 

3. Natural Resources 

Raw goods and materials available in a country that is used to create supply fall under natural resources. From land to weather to minerals to oil – everything comes under natural resources. More the available natural resources of a country, the more is its aggregate supply. 

     4. Entrepreneurship

Entrepreneurship can be defined as the drive of business owners to produce the goods that have demand. The financial income from entrepreneurship is profits.

Basically, the aggregate supply of a country depends on the wages, production costs, taxes and subsidies and inflation of a nation. 

WHAT IS AGGREGATE DEMAND AND AGGREGATE SUPPLY IN MACROECONOMICS?

In terms of macroeconomics, aggregate demand can be defined as the total demand for goods and services in an economy at a given period. Aggregate demand shows the amounts of goods and services that will people are willing to purchase at all possible price levels.

As explained earlier, aggregate supply is the total supply of goods that suppliers are willing to produce at a given period and a particular price level.

Aggregate supply comes to equilibrium with aggregate demand when the latter settles at a price level that makes consumers want to buy the product as well as suppliers to want to supply the product in the market. 

HOW DOES AGGREGATE SUPPLY WORK?

A change in aggregate supply can be due to many variables like changes in the size/quality of labour, an increase in wages, technological innovations, change in production costs, subsidies and taxes. While some of the factors like better technical innovations and quality of labour lead to positive changes in aggregate supply, other factors like increase in wages and production costs cause a downfall in the graph of aggregate supply. 

How does short-run aggregate supply differ from long-run aggregate supply?

Short run aggregate supply is affected by demand and prices only. The capital is fixed, and it is assumed that the company cannot install new equipment or a piece of machinery to increase production. Similarly, labour is fixed too, and firms cannot hire new workforce during this period. Therefore, a company has to make the most out of the resources that it already has. This is why it is considered that a company with a high short term aggregate supply is likely to make more profit in the long term.

When it comes to long term aggregate supply, price does not have a role to play in the increase or decrease of aggregate supply. In the long run, aggregate supply depends mostly on capital goods, better technological innovations and machinery that lead to an improvement in productivity and efficiency, thus affecting aggregate supply positively. Apart from capital, aggregate supply also improves due to an increase in the level of skills and education among the labour force of a country. Although independent of the price factor, long-run aggregate supply is price elastic to an extent. This means that after hitting a certain mark, supply does not get affected to the changes in the price level.

Let us try to understand this with the help of an example:

ABC Pvt. Ltd is a manufacturer of pens that produces 100,000 pens on a half-yearly basis at a total expense of $1 million. However, the cost of ink that accounts for 10% of that expense doubles itself because of a shortage. In such a case, ABC Pvt. Ltd. would be able to produce only 90,909 pens at the previous expenditure of $1 million on production. This reduction would cause a decrease in aggregate supply. The lower the aggregate supply gets, the demand for pens would eventually exceed the output of the product. Therefore, an increase in demand along with a hike in production costs would amount to a rise in the price of a pen.

SHORT TERM AGGREGATE SUPPLY– WHY IS IT AN UPWARD SLOPING CURVE?

The graph for aggregate supply, as shown above, is an upward sloping curve only when it is in the short run. You can see that the short-term aggregate supply curve is basically a relationship between price and the quantity of goods supplied. As the price changes from the expected price level, the real output shifts from the natural rate of output, thus giving the curve its upward slope as opposed to the vertically moving curve of the aggregate supply in the long run.

So, what makes the short term curve an upward sloping one? If you remember the chapters of demand and supply from microeconomics, you would know that real output is the result of capital and labour (which are the inputs of production). However, in the case of short run, the levels of capital and labour are assumed to remain fixed. The only determinant that affects supply is the price. Now, if you think as a company, would you not want to supply your goods when the rate at which they are being availed is high? Because, the higher the price, the more profit you earn. This makes the curve an upward sloping one as suppliers are ready to supply products and services when they get a higher price for it.

On a deeper level, the reason why the aggregate supply curve is upward sloping in the short run is a bit more complicated. The explanation can be given in four ways through 4 basic explanatory models namely the sticky-wage model, the imperfect-information model, the worker- misperception model, and the sticky-price model. Let us try to understand them.

1. Sticky-Wage Model

According to the sticky-wage model, the labour market and the wages paid have a crucial role to play. In many industries, short run wages are set by contracts. When the price increases, the nominal wage remains fixed. However, the purchasing power of the salary falls as a labourer has to buy the same thing with the same wage at a higher price. When the price level rises, the real wages of labour fall. With a fall in real wages, labour becomes cheaper. This makes it possible for firms to hire more labour. With more labour at work, output increases.

2. Imperfect-Information Model

In this model, the labourers are not aware of the rise in prices or the fall in real wages. It is only the producers who are really aware of the price of the goods that they produce. When the overall price level goes high, producers consider it to be a relative increase. When the relative price level increases, the real wage increases with it. As a result, the amount of labour supplied increases too. With more labour put in by producers, the output automatically increases.

3. Worker-Misperception Model

In the worker-misperception model, wages are free to move with changes in the economy. An employee is willing to supply more work only when the expected real wage is high. When the price level rises, firms increase nominal wages. When wages are increased, workers tend to believe that real wages have also increased. Due to their misconception of a hike in real wages, they are willing to provide more labour. With increased labour, the actual output of a firm increases.

4. Sticky-Price model

Under the sticky-price model, a firm sets its prices high when they expect a high price level in the market as well. Seeing this, other competing firms also follow suit and set their prices high. Ultimately, an expected high price level leads to an actual high price level, and this leads to more output. 

LONG TERM AGGREGATE SUPPLY– WHAT CAUSES THE VERTICAL CURVE? 

Since long term aggregate supply is independent of price, the LAS curve is a vertically moving curve. Long run aggregate supply depends mostly on higher productivity of labour and increased efficiency of technology. Even as a vertical curve, the LAS witnesses shifts along the x-axis. Any change that affects the rate of real output can cause a change in the LRAS curve. However, you need to keep in mind that the curve always moves along x-axis towards the left and right while staying put at the same price level.

Here are the causes of shifts in the long run aggregate supply curve:

1. An improvement in productivity and efficiency can cause the LAC to shift to the right. Deterioration in technological efficiency would cause the curve to move to the left.
2. An increase in the stock of capital and labour resources would cause the curve to shift out and vice versa.
3. An increase in capital stock can shift out the LRAS.

Similarly, widespread diffusion of a new technology or a mass movement of workers migrating from one economy to another can affect LRAS adversely. Also, changes in the production technology used can cause a shift in the long run aggregate supply curve. Apart from these, natural disasters and state of emergencies like civil wars can have an impact on an economy’s productive potential and affect the LRAS, causing it to shift along the x-axis. 

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