1. ECON2: The National Economy
2.8 Determinants of Long-Run Aggregate Supply
How easy is it to increase supply in the long-run?
ECON2: The National Economy

2. The concept of long-run aggregate supply
2.8 What you need to know
The concept of long-run aggregate supply
The determinants of the long-run aggregate supply curve
They Keynesian aggregate supply curve
The institutional structure of the economy
The role of the banking system in the economy

3. 2.8 You should be able to: Define long-run aggregate supply
Explain and analyse the determinants of long-run aggregate supply
Illustrate the effects of changes in long-run aggregate supply on a diagram
Understand why the long-run aggregate supply curve is assumed to be vertical
Understand and explain the Keynesian long-run aggregate supply curve
Understand the importance of the institutional structure of the economy
Understand and explain the role of the banking system in providing business investment funds

4. The Difference Between Short and Long-Run
Recap.
In the short-run, all factors of production are fixed, with the exception of labour which can be hired to cover increases in aggregate demand
In the long-run, all factors of production are variable and can be increased over time
In effect, long-run aggregate supply represents the maximum possible output an economy can produce as determined by its available land, labour, capital and entrepreneurial resources

5. The Long-Run Aggregate Supply Curve
Price Level
This is known as the classical view of long-run aggregate supply.
LRAS
Y represents the maximum capacity of the economy to produce goods and services i.e. there is full employment and all resources are being used efficiently. P Y
Real National Output

6. Factors Affecting LRAS (1)
Long-run aggregate supply can shift when there is a change in the quantity and/or quality of the factors of production
Land
If additional land for production becomes available, or new primary raw materials are discovered or become available, the productive potential of the economy will improve and LRAS will increase
Labour
If there is an increase in the size of the labour force, then it might be expected that output will increase
If there is an increase in the quality of the labour force e.g. through training and education then efficiency and productivity is enhanced and LRAS will increase
If there is improved occupational or geographical mobility of labour this gives firms more flexibility in production

7. Factors Affecting LRAS (2)
Capital
An increase in the quantity, quality and productivity of capital will boost LRAS
This can often arise from improvements in technology and improved research and development
Entrepreneurship
Improved incentives to set up new businesses, or invest in the development of new goods and services, can lead to a boost in LRAS
And....Government Intervention
Governments will often use regulatory frameworks to improve the level of competition in different markets
If successful, then greater competition can drive efficiency gains amongst firms as they strive to maximise their profits

8. Shifts of the LRAS Curve
A decrease in the quantity and/or quality of factors of production will shift LRAS from LRAS to LRAS2.
Price Level
LRAS2
LRAS
LRAS1
An increase in the quantity and/or quality of factors of production will shift LRAS from LRAS to LRAS1. P Y2 Y Y1
Real National Output

9. For each of the following examples, identify the impact on LRAS.
Will there be an increase or decrease in LRAS?
Impact
Increase or Decrease?
The government introduces new immigration laws to limit the ability of migrant workers to seek employment in the UK
The government introduces tax breaks for companies that invest a portion of their profits in research and development
An extra £2bn is made available for education and training
The government raises the retirement age to 70
Pressure groups successfully block the development of “fracking”
The government invest £1bn to widen broadband coverage

10. The Keynesian AS Curve
The classical view of LRAS suggests that the economy will always produce the maximum that its factor resources will allow
Classical economists believe that markets will always function efficiently over the long-run, and so an economy will produce on the outer boundary of its production possibility curve, thus the LRAS curve is vertical, marking a maximum limit of production
John Maynard Keynes however, believed that an economy could be in equilibrium below full employment
Through his study of The Great Depression of the 1930’s, he concluded that the LRAS curve was upward sloping, and did have a vertical section (like the classical LRAS curve), but at times an economy could settle at a level of output below full employment

11. The Keynesian AS Diagram
LRAS
A = Unused capacity
Firms can increase output without increasing costs.
Price Level C
B = Limited spare capacity
As the economy nears full employment, firms find it more difficult to attract scarce resources, so prices begin to rise. B A P
C = Full capacity
There is full employment and all resources are used. FE
Real National Output
Draw a production possibility diagram to help explain the LRAS curve.

12. Shifts in the Keynesian LRAS Curve
Price Level
As per the classical LRAS curve, any change in either the quantity or quality of factors of production will shift LRAS. P
FE2 FE
FE1
Real National Output

13. Which LRAS Curve Should You Use?
It depends!
It is crucial to understand the difference between the short-run and long-run aggregate supply curves, this is a common area of testing on Section A of the ECON2 paper
In terms of the long-run, you should have an understanding of both models, as this will allow you to explain and evaluate more fully the impact of economic policy
The Keynesian version is arguably more “realistic” in its approach and can often be applied to a range of explanations regarding the behaviour of an economy, but it is worth noting that neither the classical nor Keynesian model are free from problems, and both have a number of assumptions lying behind their theory
The crucial point to note is that they are “models” and should be used as such, rather than perfect predictors of how an economy might behave

14. The Institutional Structure of the Economy
Institutions, such as the banks, play an important role in the economy
These organisations act as a support mechanism for businesses providing legal, technical or other support
They also provide access to financial support that will help businesses to invest
This gives businesses the confidence to develop their business plans, helping to increase the productive potential of the economy

15. The Role of the Banking System
The banking system provides the investment funds required for businesses
This allows for investment in capital goods such as machinery
Increased capital stock will lead to a shift to the right of the LRAS curve
A strong banking system is essential in creating the conditions required for investment
What happens when the banking system is not “strong”?

16. Multiple Choice 1
Which one of the following developments is most likely to cause the shift in the long-run aggregate supply curve from LRAS1 to LRAS2?
Growth in export markets
Improvements in the banking system that increase the funds available for investment
An improvement in consumer confidence
A sustained increase in government spending on welfare benefits
Can you explain your answer?
Price Level
LRAS1
LRAS2 B
Real National Output

17. the growth of labour productivity interest rates
Multiple Choice 2
The shift in the LRAS curve is most likely to have been caused by a fall in
the capital stock
income tax rates
the growth of labour productivity
interest rates
Can you explain your answer?
Price Level
LRAS2
LRAS1 A
Real National Output

18. as a source of investment funds for business
Multiple Choice 3
A country’s banking system is an important part of the institutional structure of the economy because of its role
as a source of investment funds for business
in determining the economy's target rate of inflation
in managing the country’s balance of payments
as a major employer of labour in the economy
Can you explain your answer? A

19. the number of immigrants entering the country the rate of interest
Multiple Choice 4
All other things being equal, which one of the following is most likely to cause a simultaneous shift to the right in both an economy’s short-run and long-run aggregate supply curves? An increase in
the number of immigrants entering the country
the rate of interest
the rate of VAT
the minimum wage rate
Can you explain your answer? A

20. 2.8 You should be able to: Define long-run aggregate supply
Explain and analyse the determinants of long-run aggregate supply
Illustrate the effects of changes in long-run aggregate supply on a diagram
Understand why the long-run aggregate supply curve is assumed to be vertical
Understand and explain the Keynesian long-run aggregate supply curve
Understand the importance of the institutional structure of the economy
Understand and explain the role of the banking system in providing business investment funds