Long-run aggregate Supply (LRAS) is a fundamental concept in economics, revealing the maximum output an economy can produce when all its resources are fully adjustable. Unlike the short run, where some factors are fixed, LRAS reflects a situation where everything can adapt over time. This page dives deep into LRAS, explaining how it’s measured by potential output and what factors cause it to shift, ultimately impacting economic growth.
Understanding Long-Run Aggregate Supply (LRAS)
Long-run aggregate supply (LRAS) refers to the total output produced in the economy when all inputs are variable. Wages and other inputs are flexible and change proportionately in response to changes in the price level. Thus, firms have no incentive to change their output when the price level changes.
In the long run, the economy fully utilizes all its resources. For this reason, long-run aggregate supply represents potential output, the maximum output an economy can produce using available resources.
Long-run aggregate supply has a vertical curve. Thus, changes in the price level do not affect aggregate output. Rather, it changes if the factors of production are more abundantly available or they are of better quality, allowing the economy to have a higher production capacity or become more productive. In addition, technology also plays an important role in increasing potential output through increasing productivity.
The vertical long-run aggregate supply curve
The long-run aggregate supply curve (LRAS) is a vertical line that is perfectly inelastic. Thus, changes in the price level do not affect aggregate output.
The reason why the long-run aggregate supply curve is vertical lies in how the inputs behave. Economists assume all inputs are variable in the long run. Thus, when the price level increases, all input costs will increase accordingly. Vice versa, input costs will also fall when the price level falls.
Hence, firms have no incentive to change their output. Changes in the price level do not encourage them to increase or cut production because it does not affect their profits. Their profit margin is constant because costs move proportionally with changes in the price level.
Neoclassical vs. Keynesian views on LRAS
Economists debate how quickly economies adjust to changes. The Neoclassical and Keynesian schools offer contrasting views on LRAS, impacting how they see short-term fluctuations influence long-term potential. Let’s explore the core differences in their perspectives on LRAS.
The Neoclassical aggregate supply curve
Neoclassical economists view the economy as operating at its full capacity. Thus, with the available resources, it is not possible to produce more.
In the Neoclassical economists’ view, the supply curve is upward vertical. Thus, price level changes do not affect aggregate output changes. Likewise, short-run factors, which affect production costs, such as wages and raw material prices, do not affect aggregate supply.
Rather, changes in long-run aggregates only change when long-run factors change. For example, the labor supply increases. This allows more people to generate output. Likewise, as their quality improves, they become more productive, enabling the economy to produce more output using available inputs.
In addition, increased capital and technological progress are other factors. Both contribute to an increase in productivity and, therefore, aggregate output.
Changes in those factors cause the long-run aggregate supply curve to shift to the right. The opposite effect holds if long-run factors change in reverse.
The Keynesian aggregate supply curve
In the Keynesian view, the economy can operate below potential output, even in the long run. Thus, there is spare capacity, which allows firms to increase their output without increasing costs. In addition, wages can become rigid, allowing businesses to respond to the rising price level by increasing output. However, the output will no longer increase once the economy reaches full capacity.
Thus, Keynesians view the aggregate supply curve as having three parts. The first part is the horizontal line where the economy is producing below capacity. Thus, there is spare capacity in the economy. As a result, businesses can increase output without increasing costs while the price level remains constant.
The second part is an upward-sloping line in which aggregate output changes proportionally in response to changes in the price level. When increasing output, the economy is operating near its maximum capacity. Thus, available resources become more scarce, pushing up the price level.
The third part is the vertical line. The economy operates at its maximum capacity. Resources are fully utilized, and thus, the aggregate output cannot increase further.
Then, if we graphed it graphically, the Keynesian long-run aggregate supply curve would look like the one below.
Factors affecting long-run aggregate supply
Changes in the price level do not affect long-run aggregate supply. Likewise, changes in input costs, such as increases in wages and raw materials, also have no effect. Rather, the change occurs when long-run factors change.
In general, the long-run factors are factors of production plus technology. Their increase allows potential output to increase because the economy has a greater productive capacity. Likewise, when they are of higher quality, the economy can also increase productivity, which makes it possible to produce more output from available resources.
Technology also plays an important role because it improves the quality of existing resources, enabling increased productivity. Long story short, the factors affecting long-run aggregate supply are:
- Availability of natural resources
- Availability and quality of human capital
- Availability and quality of physical capital
- Technology
Changes in potential output have no effect on inflation. It occurs when the long-run aggregate supply curve shifts to the right or left without impacting the price level.
Factors affecting long-run aggregate supply shift to the right
The LRAS curve shifts to the right because more factors of production (also known as economic resources) are available. In addition, their quality improvement also shifts the curve to the right.
When the LRAS curve shifts to the right, the economy’s productive capacity increases. As a result, the economy can produce more output without impacting the inflation rate.
What factors cause the long-run aggregate supply curve to shift to the right? Here are the details:
- Increased labor supply. Because more labor is available, the economy can produce more when each worker is employed. Changes in the labor supply are affected by population growth, labor force participation rates, and net immigration.
- More qualified workforce. If human capital improves, laborers will be more productive. Thus, they can produce more output using the available inputs. Improving the workforce can be achieved through training, skills development, and education.
- More natural resources are available. Thus, the economy has more raw materials to be processed into output.
- Increase in physical capital. More physical capital, like new factories and machinery, boosts an economy’s production potential. This requires investment, but that investment needs to outpace depreciation (capital wearing out). If not, the new investment just replaces what’s breaking down, and overall production capacity stays the same.
- More sophisticated physical capital. Like labor, this factor allows capital to be more productive. For example, robotic machines automate production and increase output significantly at scale. It contrasts with human-assisted machines.
- More advanced technology facilitates increased productivity in various aspects, from industrial machines to the flow of information. It also makes labor and physical capital more productive.
Factors affecting long-run aggregate supply shift to the left
If the LRAS curve shifts to the left, potential output decreases. Productive capacity shrinks, and the economy can only produce less output. This leftward shift occurs for several reasons, including:
- Resource depletion: When natural resources like minerals or fossil fuels run low, there are fewer raw materials to produce goods and services, limiting output.
- Shrinking workforce: An aging population or declining birth rates can lead to a smaller labor force, reducing the economy’s production capacity.
- Workforce skill decline: If the workforce becomes less skilled or educated, overall productivity falls, meaning less output is produced with the same resources.
- Insufficient investment: Low investment in new machinery and equipment (capital stock) can lead to a decline in overall production capacity as existing capital depreciates.
- Outdated capital stock: Relying on old or inefficient technology hinders productivity, limiting potential output.
- Technological stagnation: If research and development slow down, there are fewer advancements to improve production efficiency, leading to a decline in LRAS.
