Understanding Aggregate Supply: SRAS & LRAS

Introduction

Hello! In our previous lesson, we explored the components of aggregate demand, focusing on the consumption function and the powerful expenditure multiplier effect. We now have a solid understanding of the demand side of the macroeconomy.

To complete our model, we must turn to the supply side. This lesson introduces the Aggregate Supply (AS) curve, which describes the total quantity of goods and services that firms are willing and able to produce at different price levels. A key distinction in macroeconomics is the difference between the short run and the long run, and this distinction is central to understanding aggregate supply.

Our learning outcome for today is to plot and interpret the short-run and long-run aggregate supply (SRAS/LRAS) curves. We will explore:

• Why the short-run aggregate supply curve is upward-sloping.
• Why the long-run aggregate supply curve is vertical.
• The key factors that cause each of these curves to shift.

By the end of this lesson, you will have the final major component needed to build the full AD-AS model, setting the stage for analyzing economic fluctuations and equilibrium.

1. The Short-Run Aggregate Supply (SRAS) Curve

Let's begin with the short run. The short-run aggregate supply (SRAS) curve shows the relationship between the overall price level in the economy and the quantity of output (real GDP) that firms produce, assuming that some input prices are fixed or "sticky."

To understand the shape and characteristics of the SRAS curve, please watch the first part of the following video.

As the video explained, the SRAS curve is upward-sloping. This positive relationship between the price level and real GDP exists primarily because of sticky input prices, especially wages.

Imagine you are a business owner. Many of your costs, like employee wages, are fixed by contracts in the short run. If the price level for the goods you sell rises, your revenue increases, but your labor costs remain the same. This increases your profit margins, creating a powerful incentive to increase production. Conversely, if the price level falls while your wage costs remain high, your profits get squeezed, and you will likely reduce production.

This relationship is captured in the following graph.

The SRAS Equation

Given your analytical background, you might appreciate the formal equation for the SRAS curve, which elegantly summarizes this concept:

$Y=Y_n+\alpha (P-P_e)$

Let's break this down:

• $Y$ is the actual level of output (real GDP).
• $Y_n$ is the natural rate of output, which is the economy's potential or full-employment output (we'll discuss this more with LRAS).
• $P$ is the actual price level.
• $P_e$ is the expected price level. This is the price level that workers and firms anticipated when they negotiated wages and other input contracts.
• $\alpha$ (alpha) is a positive coefficient that measures how much output responds to unexpected changes in the price level.

This equation tells us that actual output $Y$ will exceed the natural rate $Y_n$ when the actual price level $P$ turns out to be higher than what was expected $P_e$. This directly models the sticky-wage theory: firms make higher profits and produce more when their output prices rise unexpectedly above their contractually fixed input costs.

2. Shifters of the Short-Run Aggregate Supply Curve

A change in the overall price level causes a movement along the SRAS curve. However, other events can change the cost of production for many firms simultaneously, causing the entire SRAS curve to shift. An increase in aggregate supply is a shift to the right; a decrease is a shift to the left.

The following video and reading detail these shifters.

To reinforce these ideas with some real-world context, please read the following sections from the OpenStax textbook.

Based on these resources, the main shifters of the SRAS curve are:

• Changes in Resource (Input) Prices: This is the most significant shifter.
  • Wages: An increase in nominal wages increases production costs, shifting SRAS to the left.
  • Commodity Prices: A rise in the price of key inputs like oil or steel increases costs for a wide range of firms, shifting SRAS left. A decrease in these prices shifts SRAS right. An unexpected event like this is often called a supply shock.
• Changes in Productivity: An improvement in technology or an increase in the capital stock allows firms to produce more output with the same amount of inputs. This lowers costs and shifts SRAS to the right.
• Government Actions:
  • Business Taxes: Higher taxes on businesses (e.g., corporate profit tax) are treated as a cost, shifting SRAS left.
  • Subsidies & Regulations: Government subsidies can lower costs and shift SRAS right, while costly regulations can increase costs and shift SRAS left.
• Changes in Inflationary Expectations: If firms and workers expect higher inflation in the future, they will negotiate higher nominal wages today. This raises costs and shifts the SRAS curve to the left.

3. The Long-Run Aggregate Supply (LRAS) Curve

The short run is defined by the presence of at least one fixed input price. What happens in the long run, a period long enough for all prices, including nominal wages, to become fully flexible?

In the long run, the logic of sticky wages no longer applies. If the price level doubles, nominal wages and other input prices will eventually double as well. Since both revenues and costs rise by the same proportion, firms' real profit incentives don't change, and therefore they have no reason to alter their level of production.

This means that in the long run, the economy's output is determined not by the price level, but by its fundamental productive capacity—its supply of labor, capital, natural resources, and its level of technology. This capacity is what we call potential output or full-employment output ($Y_n$).

Because the quantity supplied in the long run is independent of the price level, the LRAS curve is a vertical line at the level of potential output.

The following video masterfully illustrates how the economy adjusts from the short run to the long run, forming the vertical LRAS curve.

4. Shifters of the Long-Run Aggregate Supply Curve

Since the LRAS curve represents the economy's maximum sustainable output, it only shifts when there is a change in this fundamental productive capacity. These changes represent long-term economic growth (or decline).

You'll notice that these factors are the same ones that shift an economy's Production Possibilities Curve (PPC), which you studied in Module 1.

The key shifters of the LRAS curve are:

1. Changes in the Quantity of Resources:
   • Labor: An increase in the labor force (e.g., through immigration or a higher participation rate) shifts LRAS to the right.
   • Capital: An increase in the physical capital stock (machinery, factories) or human capital (education, skills) shifts LRAS to the right.
   • Natural Resources: The discovery of new resources can shift LRAS to the right.
2. Changes in Technology: Technological advancements that increase productivity are a primary driver of economic growth and shift the LRAS curve to the right.

It is crucial to distinguish between the shifters of SRAS and LRAS. A change in nominal wages shifts SRAS but not LRAS, because in the long run, wages adjust, and the number of workers and their skills haven't changed. However, a change in technology shifts both SRAS (by immediately lowering costs) and LRAS (by increasing long-run potential).

5. Practice and Application

Let's test your understanding. For each scenario below, determine whether it shifts the SRAS curve, the LRAS curve, both, or neither. If a curve shifts, state the direction (left or right).

Pause and think through each one before revealing the answer.

1. Scenario: The government significantly increases the minimum wage.

   • Answer: This increases the price of labor, a key input. It raises production costs. SRAS shifts to the left. LRAS does not shift because the economy's potential capacity (number of workers, technology) has not changed.

2. Scenario: A widespread adoption of a new AI technology dramatically increases worker productivity across all industries.

   • Answer: This is a change in technology. It lowers production costs in the short run and increases the economy's maximum potential output in the long run. Both SRAS and LRAS shift to the right.

3. Scenario: A major OPEC agreement causes a sharp, unexpected increase in world oil prices.

   • Answer: Oil is a critical input for many industries (transportation, manufacturing). This is a negative supply shock that increases production costs. SRAS shifts to the left. LRAS is generally considered unaffected by a change in the price of one resource, as the economy can adapt over the long run.

4. Scenario: The overall price level in the economy increases by 5%.

   • Answer: This causes a movement up along the existing SRAS curve. It does not shift either curve.

Conclusion

In this lesson, we dissected the supply side of the macroeconomy, distinguishing between the short run and the long run.

Key Takeaways:

• The Short-Run Aggregate Supply (SRAS) curve is upward-sloping because input prices (like wages) are "sticky." Higher output prices lead to higher profits and more production in the short term.
• The SRAS curve shifts due to changes in input prices, productivity, and government policies that affect production costs.
• The Long-Run Aggregate Supply (LRAS) curve is vertical at the level of potential (or full-employment) output. In the long run, all prices are flexible, so the price level does not influence the economy's output capacity.
• The LRAS curve shifts only when there are changes in the fundamental factors of production: the quantity of labor and capital, or the state of technology.

Preview of the Next Lesson:

You now understand both the Aggregate Demand and Aggregate Supply curves. In our next lesson, we will finally bring them together in the AD-AS model. We will use this powerful tool to analyze how the economy arrives at a macroeconomic equilibrium and, crucially, what happens when it doesn't—leading to recessionary or inflationary gaps.