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What’s it: Very short-run aggregate supply refers to the aggregate supply in which firms change the output to a limited extent without changing prices. In this period, prices and most production costs are fixed, so firms can only adjust their output to a certain extent. This limited adjustability is reflected in the perfectly elastic, horizontal line that represents it.
Very short run vs. short run and long run
Economists analyze aggregate supply across three distinct timeframes: very short-run, short-run, and long-run. Each time frame is characterized by the level of flexibility firms have in adjusting prices and inputs (labor, materials, equipment) in response to changes in demand. This flexibility significantly impacts how firms react to economic fluctuations and ultimately influences the shape of the aggregate supply curve.
Very short-run aggregate supply
The very short run is the period in which prices and costs are fixed. Imagine a restaurant during peak dinner hours. Prices are set on the menu, and staffing levels are predetermined. In this extremely limited timeframe, these factors are essentially fixed.
While the kitchen might be able to squeeze in a few extra orders by working more efficiently, their overall capacity for food preparation and seating is constrained. This lack of flexibility is reflected in the horizontal, perfectly elastic line representing the very short-run aggregate supply. Even if demand surges unexpectedly, prices are unlikely to rise; instead, the restaurant may reach its maximum capacity and have to turn away customers.
Short-run aggregate supply (SRAS)
The short run is a period in which some inputs are constant, allowing firms to earn higher margins when the price level rises and vice versa. As a result, firms have an incentive to increase output as long as the price level rises in the short run, allowing them to make more profits. Conversely, a fall in the price level disincentives them, prompting them to cut output.
Now consider a few weeks or months after the busy season. The restaurant can now adjust some aspects of production. They might order additional ingredients based on recent demand trends or hire temporary staff for upcoming events. Crucially, they also have some wiggle room on prices. If demand remains high, they might introduce limited-time promotions or adjust menu prices slightly to maximize profits.
This newfound flexibility is reflected in the upward slope of the SRAS curve. As demand increases, firms are incentivized to expand output (and potentially raise prices) in the short run to meet demand and generate higher profits. Conversely, a decrease in demand might lead them to reduce output or offer discounts to attract customers.
Long-run aggregate supply (LRAS)
The long run is the period in which all inputs are variable. Thus, there is no incentive for companies to change their production. Moreover, an increase in the price level does not incentivize them to increase production because costs increase proportionally. As a result, profit margins are constant, and they do not earn more by increasing output. Conversely, costs also fall when the price level falls in the long run. As a result, profit margins have not changed.
Fast-forward a year or more. The restaurant can now make significant changes to influence its production capacity. If demand consistently exceeds its capabilities, it might invest in expanding its kitchen space, purchasing additional equipment, or hiring more permanent staff. In the long run, these adjustments are possible because all inputs, including physical facilities and labor, become variable.
However, it’s important to note that expanding production also comes with increased costs for rent, equipment, and wages. In the long run, price changes primarily reflect changes in production costs. An increase in the price level might incentivize firms to expand production in the long term, but their costs will also rise proportionally. This means profit margins are not directly affected by price changes in the long run, leading to a vertical long-run aggregate supply curve.
Why the flat curve? Spare capacity explained
The horizontal line that represents very short-run aggregate supply reflects a key concept: spare capacity. Spare capacity refers to the unused resources or production potential that firms have readily available within their existing operations. This allows them to ramp up output to a certain extent in the very short run without needing to adjust prices.
Utilizing spare capacity:
- Intensifying production: Firms can squeeze out more output by running existing machinery for longer hours or increasing the number of workers per shift. Imagine a bakery with extra oven space that can be used to bake more bread during peak hours.
- Utilizing idle resources: Previously unused equipment or underutilized employees can be brought online to contribute to increased production. A factory might have spare assembly lines that can be activated to meet a sudden surge in demand for a specific product.
However, spare capacity is not limitless. There are constraints that prevent firms from endlessly increasing output in the very short run:
- Physical capacity: Facilities and equipment have a maximum output limit. A restaurant might have limited seating and kitchen space, restricting the number of customers it can serve at once.
- Inventory limitations: Firms might not have enough raw materials or finished goods readily available to significantly boost production, or a clothing store may not have enough extra fabric or pre-made garments to fulfill a large unexpected order immediately.
Once spare capacity is exhausted, firms enter the short-run timeframe. Here, they have more flexibility to adjust prices and some variable costs (like labor) to meet changes in demand. This shift in flexibility is reflected in the upward slope of the short-run SRAS curve.
Real-world examples of very short-run aggregate supply
Understanding very short-run aggregate supply through abstract concepts is helpful, but let’s see it in action! Here are some real-world examples that illustrate how spare capacity influences production decisions:
Coffee shop rush: Imagine a coffee shop during their morning rush hour. Prices are already set on the menu, and staffing is predetermined. Even if there’s a sudden surge in customers, the shop can only make a limited number of coffees at once due to the number of available machines and baristas. However, they can utilize spare capacity by:
- Intensifying production: Baristas might work faster, prioritizing speed and efficiency to serve more customers within the timeframe.
- Utilizing Idle resources: If there’s an extra espresso machine available but usually unused during the mornings, it can be quickly used to increase coffee output.
Airline during peak season: Airlines face fluctuating demand throughout the year. During peak travel seasons, flights might fill up quickly. In the very short run, the airline can’t add more planes or crew members. However, they might utilize spare capacity by:
- Maximizing seat capacity: Airlines might sell all available seats, including those typically left empty for passenger comfort on less busy routes.
- Utilizing standby lists: Passengers on standby can be moved to fill any last-minute cancellations, maximizing the number of paying customers on a flight.
These examples showcase how firms leverage spare capacity in the very short run to meet unexpected demand fluctuations without resorting to immediate price adjustments. However, it’s important to remember that this spare capacity is finite, and once exhausted, firms need to enter the short-run timeframe to adjust production and potential pricing strategies.
