AGGREGATE SUPPLY ECONOMICS – A COURSE COMPANION BLINK & DORTON, 2007. p179-185.

Introduction to Aggregate Supply Definition Aggregate Supply is the total amount of goods and services that all industries in the economy will produce at a given price level. It is essentially the sum of the supply curves of the industries in the economy. In contrast to aggregate demand, it is necessary to distinguish between the short run and the long run when looking at aggregate supply.

SHORT RUN AGGREGATE SUPPLY CURVE Graphically the short run aggregate supply curve (SRAS) looks very much a like a microeconomic supply curve in that it is upward sloping. There is a positive relationship between the price level and the amount of output that a country’s industries will supply.

Short Run Aggregate Supply At any given price level, industries will supply a certain level of output. What is the short run? In macroeconomic analysis, the short run is defined as the period of time when the prices of the factors of production do not change. Most importantly, the price of labour, (the wage rate) is fixed.

Short Run Aggregate Supply: Increasing Output If a larger level of output is produced, firms are likely to face higher average costs of production. In order to produce more, firms will have to provide incentives to workers to produce a larger amount. Most commonly this is done by paying “overtime” wages. This might be one and half times the normal wage and so costs rise.

Short Run Aggregate Supply: Increasing Output HL students should recall the law of diminishing returns. Marginal and average costs will rise as output increases in the short run. In the short run, an increase in output will be accompanied by an increase in average costs. Industries will pass on an increase in costs in the form of a higher price level. This explains why the SRAS curve is upward sloping.

Shifts in Short Run Aggregate Supply (SRAS) Just as with the microeconomic supply curve, a change in anything other than the price will lead to a shift in the whole curve. Thus a change in any of the factors, other than the price level, will result in a shift of the SRAS curve. This may be referred to as “supply side shocks”

SHIFTS IN SHORT RUN AGGREGATE SUPPLY This graph shows an increase in the short-run aggregate supply from SRAS1 to SRAS2 and a decrease in SRAS from SRAS1 to SRAS3.

Supply Side Shocks The most straightforward explanation of supply-side shocks is that they are factors that cause changes in the cost of production. Similar to microeconomic analysis, a decrease in costs results in an increase in aggregate supply while an increase in costs results in a decrease in aggregate supply.

CHANGES IN THE COSTS OF PRODUCTION A change in Wage Rates An increase in wages will result in an increase in the cost of production to firms, and therefore a fall in aggregate supply. If for example, the government raised the legal minimum wage, it would increase labour costs. If labour unions were to negotiate higher wages for workers as part of enterprise bargaining, this would also results in a fall in the SRAS.

CHANGES IN THE COSTS OF PRODUCTION A change in the costs of raw materials For a change to have an effect on aggregate supply, we are assuming an increase in the price of significant, widely used raw materials. An increase in the price of rubber would affect industries that use rubber as a factor, but this might not be significant enough to affect aggregate supply noticeably. However, a change in the price of oil, would have an impact on all industries, as oil is widely used in most production processes.

CHANGES IN THE COSTS OF PRODUCTION A change in the price of imports If the capital or raw materials used by the country’s industries are imported, then a rise in import prices will increase the costs of production. This can occur due to changes in the exchange rate of a country’s currency.

Combining AD & AS in the Short Run The economy will operate where aggregate demand is equal to aggregate supply.

SRAS & AD IN THE SHORT RUN At the average price level (PL), all the output produced by the country’s producers is consumed. There is no incentive for producers to either increase output or raise prices.

LONG RUN AGGREGATE SUPPLY There is considerable debate among economist regarding the long rung aggregate supply curve (LRAS). The different-shaped LRAS curves lie at the basis of controversies about appropriate policies to be followed by governments.

LONG RUN AGGREGATE SUPPLY There are two main schools of thought, concerning the shape of the LRAS. The approach of the famous economist John Maynard Keynes – Keynesian Economics. VS... The approach of neo classical economists or free market economists

The Keynesian LRAS shows three possible phases KEYNESIAN LRAS CURVE The Keynesian LRAS shows three possible phases

KEYNESIAN LRAS SUPPLY CURVE: Phase 1 In this view the aggregate supply curve will be perfectively elastic at low levels of economic activity. Producers in the economy can raise their levels of output without incurring higher average costs because of the existence of spare capacity in the economy. That is, there are high levels of unused factors such as unemployed labour an underutilized capital. Should there be a need for greater output these can be used to their fullest capacity at constant average costs.

KEYNESIAN LRAS SUPPLY CURVE: Phase2 As the economy approaches its potential output (Yf) and the spare capacity is “used up” the economy’s available factors of production become increasingly scarce. As producers continue to try to increase output, they have will have to bid for the increasingly scarce factors. Higher prices for the factors of production mean higher costs for the producers, and the price level will rise to compensate for the higher costs. A upward sloping LRAS curve can be seen at phase 2.

KEYNESIAN LRAS SUPPLY CURVE: Phase 3 When the economy reaches its full capacity (Yf) it is impossible to increase output any further because all factors of production are fully employed. This suggests that the LRAS is perfectly inelastic as shown in phase 3.

Full Capacity in an Economy Full capacity of the economy is shown as Yf. This is really a simplification This level of output is known as the “full employment level of output” It is important to understand that full employment does not mean that there is no unemployment at all.

NEO CLASSICAL LRAS Neo-classical economists, also known as free market economists, do not really acknowledge or accept the first two stages of the Keynesian supply curve. It is the assumption of the neo-classical school, that the LRAS curve is vertical at all price levels, even at very low price levels. Thus the LRAS curve is independent of the price level

NEO CLASSICAL LRAS CURVE The LRAS curve is independent of the price level. The price level may rise from P1 to P2, but the level of output does not change.

THE LRAC CURVE: THE DIFFERENCE BETWEEN THE NEO-CLASSICAL AND KEYNESIAN PERSPECTIVE: NEO-CLASSICAL PERSPECTIVE KEYNESIAN PERSPECTIVE We can only increase national income by new supply policies even during periods of low aggregate demand. Price level is not relevant We can increase aggregate demand without the need for supply side policies, when starting from a position of low demand.

SHIFTS IN LRAS As a country’s factors of production are constantly changing, we would expect to see steady increases in its LRAS. This is effectively an illustration of potential economic growth. An outward shift of a country’s LRAC curve means that its productive potential has increased. In fact, a shirt in the LRAS curve can be likened to an outward shift of the production possibilities curve. (PPC)

A shift in the LRAS curve can be shown from a either a Keynesian perspective or a neo classical perspective.

SHIFTS IN THE LRAC CURVE The increase in the full employment level of output is equivalent to the outward shift of the PPC. (Production Possibilities Curve)

What will cause the LRAS curve to shift to the right? The LRAS curve will shift to the right if there is an improvement in the quality of the factors of production or an increase in the quantity of the factors of production. For example, technological advances might make capital more productive, thus shifting the LRAS curve. Improvements in education might make existing labour more productive. Discoveries of new sources of raw materials will increase the quantity of goods produced.

What will cause the LRAS curve to shift to the right? Increasing the quantity of the labour force will also shift out the LRAS. Government policies that are put in place to increase the long-run aggregate supply of the economy are known as supply-side policies.

SUPPLY SIDE POLICIES The overarching goal of supply side policies is to increase the potential output of the economy by increasing the quantity of the factors of production and or improving the quality of the factors of production. Supply side policies can be divided into two categories: Market Oriented policies Interventionist policies

MARKET ORIENTED SUPPLY SIDE POLICIES These policies focus on allowing markets to operate freely with minimal government intervention. The word “incentives” is often used in describing these policies, as they are designed to increase the incentives for labour to work hard and more productively. They also designed to increase the incentives for firms to increase productivity.

MARKET ORIENTED SUPPLY SIDE POLICIES There are several market oriented supply side policies including: Reduction in Income Taxes Reductions in Corporation Taxes Reduction in Trade Union Power Reduction or elimination of Minimum Wages Reduction in Unemployment Benefits Deregulation Privatisation

MARKET ORIENTED SUPPLY SIDE POLICIES Reduction in Income Taxes If people work harder and make more money it is possible that they will have to pay higher taxes on the higher levels of income. This may act as a disincentive to work. If taxes are reduced, it is hoped that there will be greater incentive for labour to work harder and to become more productive, thus increasing the potential output of the economy.

MARKET ORIENTED SUPPLY SIDE POLICIES Reductions in Corporation Taxes If businesses are able to keep more of their profits, then they will have more money available for investment (Well at least in theory!) As investment is the addition of capital stock to the economy, this will increase the potential output of the economy. Moreover, if business know that they are going to be able to keep a larger share of their profits, rather than give it to the government in taxes, then they will have more incentive to produce efficiently.

MARKET ORIENTED SUPPLY SIDE POLICIES Reductions in Trade Union Power It if often perceived that trade unions push wages up too high and increase the costs of production to firms. Following this, it can be argued that a reduction in trade union power will reduce the ability of unions to negotiate high wages and therefore lower the costs of production to firms, thus increasing their potential output. Argument Against However, one of the main goals of unions is to protect the rights of workers, and reduced union power, may result in worker exploitation.

MARKET ORIENTED SUPPLY SIDE POLICIES Reduction or Elimination of Minimum Wages It can be argued that a government set minimum wage keeps the price of labour above its free market level. If the minimum wage were to be abolished, then this would also decrease the costs of production and increase aggregate supply. Argument Against While this might provide some benefit in terms of the overall growth of the economy, it will reduce living standards for those workers on the minimum wage.

MARKET ORIENTED SUPPLY SIDE POLICIES Reduction in Unemployment Benefits If unemployed people are given generous unemployment benefits from the government, it may be argued that they have less incentive to find jobs. Market oriented supply-side economists would recommend that unemployment benefits be reduced to encourage unemployed people to take the available jobs in the economy. Of course this policy is only appropriate if jobs are available.

MARKET ORIENTED SUPPLY SIDE POLICIES Deregulation If governments have placed many regulations on the operations of business, then this may increase their costs of production, thereby reducing aggregate supply in the economy. A reduction in the number and or severity of the regulation (deregulation) will lower business costs and increase aggregate supply. Argument Against Unfortunately this might include reduced regulations on safety or environmental standards and this can have negative consequences for workers and the environment.

MARKET ORIENTED SUPPLY SIDE POLICIES Privatisation This is the sale of public, government owned firms to the private sector. According to market oriented economists, privately owned profit-maximising firms will be much more efficient and productive than government run firms. They will have incentive to increase potential output. Argument Against ??

MARKET ORIENTED SUPPLY SIDE POLICIES Summary All of the policies previously mentioned emphasize the reduced role of the government in the economy and the importance of allowing all markets, especially labour markets to operate freely.

INTERVENTIONIST SUPPLY SIDE POLICIES As the name suggests, there policies are based on the idea that the government has a fundamental role to play in actively encouraging growth. They include the following: Education & Training Research & Development (R&D) Provision of Infrastructure Improved Information

INTERVENTIONIST SUPPLY SIDE POLICIES Education and Training In order to constantly increase the quality of labour, it is the responsibility of the government to ensure that education and training facilities are geared to providing the necessary skills and knowledge for a dynamic economy. This is related to both the skills and knowledge that young people need to help them enter the labour force and also the retraining of workers to help them enter the labour force. It also involves the retraining of workers to help them adjust to changing economic circumstances. Such training can take places in schools, universities, training institutions and apprenticeship programmes.

INTERVENTIONIST SUPPLY SIDE POLICIES Research & Development (R&D) It is important that an economy’s firms are able to stay up to date with modern developments to develop new production techniques and to constantly seek improved methods of production. All of these may increase the economy’s potential output, but all involve extensive spending on R&D.

INTERVENTIONIST SUPPLY SIDE POLICIES Research & Development (R&D) Tax Incentives Governments can actively encourage R&D by firms by offering tax incentives. For example, they could allow firms not to pay taxes on the retained profits used for R&D. This is known as a tax credit. Firms may be reluctant to spend on R&D if they think they will not be able to reap the full benefits of their spending.

INTERVENTIONIST SUPPLY SIDE POLICIES Research & Development (R&D) Governments can also encourage R&D by guaranteeing intellectual property rights such as patents and copyrights. Alternatively governments themselves could finance R&D in public research facilities and universities.

INTERVENTIONIST SUPPLY SIDE POLICIES Provision of Infrastructure The productive potential of an economy will be enhanced by improved infrastructure, such as better transportation linkages and telecommunications.

INTERVENTIONIST SUPPLY SIDE POLICIES Improved Information Governments can finance trade fairs to facilitate the sharing of expertise and information among a country’s firms.

INTERVENTIONIST SUPPLY SIDE POLICIES At what cost?? All interventionist policies have significant costing implications and governments must weigh up the opportunity costs of such spending. The benefits of such spending are likely to be more evident in the long term than in the short term.

Create a Quiz Size Up to the Following Online Quiz Maker http://www.proprofs.com/quiz-school/register.php Create a Multiple Choice Quiz with 25 Questions based on the Aggregate Supply PowerPoint Slides.

EXAMINATION QUESTIONS Short Response Questions (10 marks each) 1. With the help of a diagram, explain three possible causes of a decrease in the SRAS curve. 2. With the help of diagrams, explain the difference between the Keynesian LRAC and the neo- classical LRAC. 3. How might a reduction in taxes be considered both a demand-side policy & a supply side policy.

EXAMINATION QUESTIONS Essay Question 1a. Using a diagram, explain the concept of potential economic growth (10 marks) 1b. Evaluate three policies that might be used to increase LRAS.