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Short-run aggregate supply (SRAS) is a crucial concept in economics. It reveals how much an economy produces (real GDP) at different price levels. Unlike the long run, where all factors are adjustable, the short run has some “sticky” elements, like wages. This article dives deep into this relationship, explaining how the SRAS curve behaves and what factors cause it to move.
Understanding Short-Run Aggregate Supply (SRAS)
Short-run aggregate supply refers to aggregate output when some costs are variable. If we plot the curve, it has a positive slope, where aggregate output increases as the price level increases and vice versa.
The positive slope is due to several costs, such as wages, being inflexible. They tend to be rigid and do not fully adapt to changes in the price level. Thus, changes in the price level impact profit margins and ultimately affect business decisions related to increasing or decreasing production.
For example, wages and some other input costs remain constant when the price level rises. Thus, the profit margin is higher. This situation encourages businesses to increase output to earn more profits.
The role of wage rigidity
The wage rigidity theory (or sticky wage theory) explains why the short-run aggregate supply curve slows upward. If wages are sticky, profit margins rise when the price level rises. This situation incentivizes firms to increase output to achieve more profit. Conversely, profits fall if the price level falls because wages are unchanged, forcing them to cut production.
Wages are inflexible and change proportionately as the price level rises due to, among other things, employment contracts. In the short run, companies do not immediately revise their workers’ contracts by increasing wages to match the rising price level. Likewise, when the price level falls, wages will not necessarily fall. As a result, employment contracts make wages rigid.
In addition to employment contracts, wage rigidity is also caused by:
- Minimum wage
- Labor market regulations
- Union’s bargaining power
Short-run vs. Long-run aggregate supply
Aggregate supply behaves differently in the short run and long run. Some inputs are sticky in the short run. But, conversely, all inputs are variables in the long run. This assumption has implications for the curve and the factors affecting aggregate supply.
Short-run vs. Long-run aggregate supply curves
Because wages and some input prices are constant, an increase in the price level increases the firm’s profit margin. This situation encourages them to increase output to reap higher profits.
Conversely, wage rigidity prevents firms from reducing costs when the price level falls. As a result, profit margins decrease, and firms cut output.
Long story short, aggregate supply is positively related to the price level in the short run. An increase in the price level increases aggregate supply, and vice versa. Suppose we plot this on a graph, where the X-axis represents aggregate output and the Y-axis represents the price level. In that case, the short-run aggregate supply curve (SRAS) has an upward slope.
In contrast, economists define the long run as the period in which all inputs are variable. Thus, input costs will rise and fall in proportion to changes in the price level. For example, if the price level rises, they will rise proportionally. Conversely, if the price level falls, they will also fall.
Because input costs adjust proportionately, the profit margin does not change. Thus, firms have no incentive to increase production or decrease production. In other words, changes in the price level do not affect aggregate output in the long run. As the result, the long-run aggregate supply curve forms a vertical line if we graph it.
Determinants of short-run aggregate supply
Changes in the price level only affect short-run aggregate supply but not long-run aggregate supply. And the change causes aggregate output to move along the short-run aggregate supply curve.
In addition, changes in short-run aggregate supply are also affected by changes in input costs, such as changes in raw material prices, nominal wages, taxes, subsidies, and exchange rates. In contrast, these factors do not affect long-run aggregate supply.
Long-run aggregate supply changes if the quantity and quality of the factors of production change. For example, more advanced technology allows the economy to produce more goods and services. Likewise, increased physical capital increases productive capacity, making it possible to produce more output. These factors also affect aggregate supply in the short run.
Shifts in the short-run aggregate supply curve
In the curve above, economists use the price level to explain changes in aggregate output (real GDP). Then, they plot aggregate output for each price level to produce a short-run aggregate supply curve. Thus, a change in the price level will cause aggregate output to change, but it simply moves along the curve. It doesn’t shift the curve right or left.
The short-run aggregate supply curve shifts to the right or left when the non-price determinant changes. These factors may affect production costs. Or they affect the productive capacity of the economy.
Several factors cause the short-run aggregate supply curve to shift:
- Input price
- Future price expectations
- Business tax
- Production subsidies
- Exchange rate
- Labor supply and quality
- Capital stock and its quality
- Technology
Factors causing the short-run aggregate supply curve rightward shifts
The Short-Run Aggregate Supply Curve (SRAS) isn’t set in stone. Several factors can cause it to shift to the right, indicating an increase in short-term production capacity. This means the economy can produce more at any given price level.
- Input prices fall. Changes in the prices of inputs such as wages, raw materials, and energy impact profit margins. If their prices fall, production costs fall, increasing profit margins. This encourages businesses to increase output.
- Future prices rise. Expectations of future prices impact businesses’ decisions to change their production and affect their optimism (pessimism) about future profits. If companies expect prices to rise in the future relative to the general price level, they see higher profit margins. To get more profit, they will build up inventory by increasing output. If more firms become optimistic, aggregate output will rise.
- Business taxes are down. Lower taxes reduce production costs per unit. As a result, profits increase, prompting businesses to increase output.
- Production subsidies. Subsidies work in reverse compared to taxes. An increase in subsidies helps firms reduce costs, encouraging them to increase output.
- The exchange rate appreciates. The appreciation makes the imported goods’ prices – such as raw materials, capital goods, and energy – cheaper. As a result, production costs decrease. And companies enjoy higher profit margins and are encouraged to increase production.
- The labor supply is increasing, and/or its quality is improving. Therefore, the economy can produce more output when more labor is available. Likewise, laborers become more productive and can produce more output using the same input as they become more qualified.
- Capital is more available and of higher quality. For example, the economy produces more output when more machines are available. Likewise, technologically more sophisticated machines (quality) also allow the economy to produce more output with the same output.
- More advanced technology. More advanced technology makes labor and capital more productive and increases aggregate output.
Factors causing the short-run aggregate supply curve leftward shifts
Short-run aggregate supply falls when the above factors work in reverse. So, in short, the short-run aggregate supply curve shifts to the left because:
- Input price goes up: When costs of raw materials, wages, or energy rise, production becomes more expensive. Businesses are discouraged from producing as much, shifting SRAS left.
- Future prices fall: If businesses anticipate future prices to fall, they are less motivated to produce now. This decreases current output, shifting SRAS left.
- Business tax increases: Higher taxes eat into profits, making production less attractive. Businesses may cut back, shifting SRAS left.
- Subsidies in trim: Government subsidies help reduce production costs. If subsidies are reduced, costs rise, and businesses may produce less, shifting SRAS left.
- Domestic currency depreciates: A weaker domestic currency makes imports more expensive. This can increase production costs and cause a leftward shift in SRAS.
- Labor supply is reduced: Fewer workers available to produce goods and services means a decline in overall output, shifting SRAS left.
- Lower quality workforce: If the workforce has lower skills or productivity, less output is produced with the same resources, shifting SRAS left.
- Capital stock decreases: When fewer machines and equipment are available, production capacity is limited, causing a leftward shift in SRAS.
- Capital quality is deteriorating: Outdated or malfunctioning machinery reduces production efficiency, leading to a leftward shift in SRAS.
- Technology setback: Technological advancements can improve productivity. Conversely, setbacks can hinder production, shifting SRAS left.
