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Aggregate Supply

The total quantity of output supplied in an economy over a period of time depends on the quantities of input of factors of production. The ability of firms to vary output in the short run will be influenced by the degree of flexibility the firms have in varying inputs. Therefore it is necessary to distinguish between short-run and long-run aggregate supply.

In the short run firms may have little flexibility to vary their inputs. Wages are usually fixed and for firms to vary output they would need to vary the intensity of utilisation of existing inputs. For example by paying workers overtime; they may only do this in response to higher prices. Therefore in the short run aggregate supply (SAS) will be upward sloping.

Firms will not want to operate in this way in the long run as it is not good practise to be permanently paying workers overtime. In the long run firms will adjust their working practices and hire additional workers.

The 3-step LRAS Curve

Above is the informal SRAS curve; the formal curve has 3 distinguishable features. This is what the Keynesians believe the curve to appear like. Monetarists believe the LRAS curve to be inelastic.

At low levels of real output (towards the left) firms have spare capacity (unused factory space, equipment and workers that are working unproductively) and can increase output easily without paying overtime.

At the point where the curve is no longer elastic (the gradient increases) businesses are trying to increase output using overtime and bonus payments, this increases the cost of production slightly which is why the price level increases. 

At the point where the curve is inelastic/vertical no more output can be obtained without a shift of the LRAS curve. All available resources are fully employed. This is known as the maximum potential output and is the same point as full employment (although not including frictional unemployment). The points between this potential and where the actual economy is at is the unemployment level. From this we can see the trade off between employment and inflation. At the maximum potential output any increased aggregate demand would only result in inflation as absolutely no more output can be produced. Therefore it would be ideal for the economy to be operating at the bottom of the vertical curve with maximum potential output but relatively low inflation.

Page last updated on 20/10/13