What’s it: 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 have no effect on 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.
How to describe the long-run aggregate supply curve?
The long-run aggregate supply curve (LRAS) is a vertical line. It shows 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.
The Neoclassical aggregate supply curve
Neoclassical economists view the economy as operating at its full capacity. Thus, the available resources are 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, have no effect on aggregate supply.
Rather, changes in long-run aggregates only change when long-run factors change. For example, the labor supply increases. It allows output to be generated from more people. 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 causing an increase in 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; 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.
What factors affect 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
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.
What causes the long-run aggregate supply curve to 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 productive capacity in the economy 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 is employed. And 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. An increase in capital stock allows the economy to increase its productive capacity. It requires investment in new property, plants, and equipment.
And the investment must be higher than depreciation (in economics, we call it the capital consumption allowance). Otherwise, the investment does not result in an increase in the capital stock because it does not adequately replace the depreciating capital, for example, due to wear and tear.
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. Technology facilitates increased productivity in various aspects, from industrial machines to the flow of information. It also plays a role in making labor and physical capital more productive.
What causes the long-run aggregate supply curve to 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:
- Natural resources are depleted, so fewer raw materials are available for processing into output.
- Less labor is available, for example, due to an aging population and low birth rate.
- Poorer workforce quality, so their productivity is lower.
- The declining capital stock, for example, due to low investment, is insufficient to compensate for depreciation.
- Poorer quality of the capital stock, for example, relies on conventional technology or old machines.
- Technological setbacks, for example, due to low research and development.
What to read next
- Aggregate Supply: Types, Curves, and Determinants
- Long-Run Aggregate Supply: Its Curve And Influencing Factors
- Short-Run Aggregate Supply: Its Curve and Determinants
- Supply Shock: Examples, Causes, Effects
- Very Short-Run Aggregate Supply: Its Curve and a Brief Explanation