Introduction

We discussed in the introduction to macroeconomics that macroeconomics deals with an economy as a whole, and uses the concepts of aggregate demand (“AD”) and aggregate supply (“AS”) – the total demand and supply within an economy.

One of the most important concepts in macroeconomics is Gross Domestic Product ("GDP"), which is the measure of output of an economy and (generally speaking) shows how wealthy a country is. Broadly speaking, governments (should) want the best for their countries and citizens, and therefore a large part of government policy is concerned with sustainably growing GDP and keeping inflation under control.

GDP and its growth are determined by the interaction between AD and AS. In our last article, we discussed the circular flow of income and AD, and we now turn to look at AS more closely.

AS is a difficult topic and there is a lot of ground to cover, because economists disagree about the shape of the long-run AS ("LRAS") curve. Two of the most well-known schools of thought on this are the classical school and the Keynesian school (named after John Maynard Keynes, an influential British economist whose ideas fundamentally changed the theory and practice of macroeconomics). Further, there have been more modern developments which also impact how we now think about AS.

We therefore split AS into four articles as follows:

1. Introduction to AS (this article);
2. Classical AS;
3. Keynesian AS; and
4. Conclusion of AD and AS (which also discusses a more moderate theory of AS).

In this article we discuss what AS is, the factors of production, and shifts in the AS curve.

What is aggregate supply?

AS is the total supply of goods and services within an economy at given price levels. If we took all the supply curves for all firms within an economy and brought them together, this would produce the short-run AS curve (“SRAS”).

A conceptual way to think of AS is that it is an amalgamation of the factors of production within an economy, which we discuss below.

Since supply curves are upward sloping, so is the SRAS - see figure 1.

The short-run is defined as a period over which the prices of at least one (and perhaps more) of the factors of production are fixed i.e. not variable. The factor of production that is usually assumed to be fixed in the price of labour (i.e. wages).

The long-run is a period over which the prices of all factors of production are variable. Economists disagree about the shape of the LRAS curve, which we deal with in the next few articles.

Further, when constructing a single SRAS curve, we assume that the quantity of factors of production at given price levels, and their quality, are fixed – the ceteris paribus (all things being equal) assumption. A change to these results in a shift in the SRAS curve.

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Factors of production

The factors of production are the raw constituents required to produce / supply goods and services, and include land, labour, capital and (for some economists) entrepreneurship.

Land

‍Both land and natural resources used in production. This could include, for example, farmland, office space, oil, plastics, metals etc.

How important land is as a factor of production within an economy will depend on the make-up of that economy. For example, if the economy is heavily focused on the production of natural resources (oil, gas, metals etc), then having extractable sources will be vital. The same would apply for economies with large construction sectors – you need land to build on!

However, land may be less important in an economy that is more heavily services-based. For example, the UK has large financial and legal sectors. Professionals within these fields can now work partly from home, and many firms are downsizing offices to take this into account. Accordingly, the availability of land may be less important for the UK’s productive capacity (at least in these spheres).

Labour

The human resources used in the production / supply of goods and services. This includes all the time spent by workers, in addition to their knowledge, skills, experience, abilities etc. Knowledge, skills etc of workers is also known as human capital.

The type of labour differs between sectors, and could include time and effort spent on building a house, writing code, drafting contracts, performing in the West End, and everything else in between.

Capital

Physical capital, being the human-made assets used in production, such as factory machinery, vehicles, computers etc. Also, financial capital i.e. money.

Some economists do not count financial capital as a factor of production, because it is not itself used in production, but is used to acquire of the other factors. However, financial capital is used directly by financial institutions in the production or supply of their products / services, and so others may include it to some extent.

Entrepreneurship

The knowledge, ability, and willingness to bring together the factors of production to produce / supply goods or services. This also includes the willingness to take on risk e.g. the risk that the production / supply may not go smoothly, that people may not want to buy your goods or services, that you may lose any financial capital invested etc.

Shifts in the aggregate supply curve

Quantity, price and quality

The AS curve will shift if there is a change to the quantities / prices of the factors of production, or their quality (productivity):

‍Quantities / prices – these can be considered together because they are causally linked (see article on supply and demand). In short, this is because the quantities and prices of the various factors of production are determined by the interaction between the supply and demand for those factors; if the quantities supplied or demanded change, so will the price.  

Quality (productivity) – this encompasses how effective a factor is in the production / supply of a good or service compared to its cost (price). There may be technological and other advances in the long term – better machinery, more effective methods of production, improved know-how – increasing the effectiveness of factors of production in the production / supply of goods and services.

By way of (imaginary) example, a tractor may cost £50,000 to acquire and run for the year, whereas field labour may cost £20,000. However, a tractor may be able to plough 50 times as many fields as a human; it would cost £1,000,000 for the same amount of work to be done by a human alone compared with £50,000 for a tractor. The quality of the tractor in ploughing fields is therefore better than a human working alone.

The AS curve will shift in response to a change in the quantities / prices or quality of the factors of production as follows:

1. If quantities increase (and therefore prices decrease), the AS curve shifts outwards;
2. If quantities decrease (and therefore prices increase), the AS curve shifts inwards;
3. If quality increases (i.e. effectiveness in production increases in comparison to overall costs), the AS curve shifts outwards;
4. If quality decreases, the AS curve shifts inwards. However, given the nature of human advancement, it is less likely that the quality of a factor of production will decrease.

Shocks and the short-run

Shifts in the AS curve by definition are less likely to occur in the short-run (since the price of at least one factor of production is fixed). Further, it takes time for the quantity (and therefore price) or quality of a factor of production to increase or decrease – which is more likely in the long-run.

In the short-run, it is therefore more likely that only shocks to the economy will cause a change to the quantity / prices of factors of production and a shift in the AS curve. Such shocks are less likely to cause any change to the quality of the factors of production (given the nature of human advancement).

Examples of shocks include:

1. Human conflict (e.g. war), which may impact the quantity (and therefore price) of natural resources, and also labour in the place of war. For example, the war on Ukraine decreased the overall supply of oil and natural gas (natural resources, which are included in the land factor of production), which pushed up prices;
2. Natural disasters, which could impact the quantity (and therefore price) of various factors of production – including land (if land or natural resources are destroyed or temporarily unavailable), labour (if people are unable to work e.g. during the Covid-19 pandemic) and capital (e.g. if factories are destroyed or cannot be used);
3. Changes to tax on businesses (e.g. VAT or corporation tax) which in turn affects the price of factors of production (higher tax = higher cost for factors of production, lower tax = lower cost for factors of production);
4. Shocks to wage levels e.g. increase in minimum wage, which is a forced (rather than market determined) rise.

Consider what other shocks might cause the quantities / prices of factors of production to be impacted in the short run.

Policy and economic growth

The AS curve is more likely to shift in the long-run.

Government policies, developments in technology and know-how, the output of human effort, and market forces will have longer to take effect – all of which are likely to impact the quantity / prices and quality of the factors of production, thereby causing shifts in the AS curve.

We discuss this in further detail in our article on supply-side policies.

Conclusion

You should now have a basic understanding of AS (at least in the short-run), the factors of production, the difference between the short-run and long-run, and causes of shifts in the AS curve. In summary:

• AS is the total supply of goods / services within an economy;
• Conceptually, AS can be thought of as an amalgamation of the factors of production: (i) land (including natural resources and land); (ii) labour; (iii) capital (human made assets, and (for some economists) financial capital); and (iv) entrepreneurship;
• In the short-run, the AS curve is upward sloping;
• The AS curve shifts when there is a change to the quantities / prices or quality of the factors of production;
• The short-run is defined as a period in which the price of at least one of the factors of production is fixed (usually the price of labour). The long-run is a period over which the prices of all factors of production are variable;
• Shifts in the AS curve are less likely in the short-run than in the long-run, and it is more likely that only shocks will cause shifts in the SRAS curve. In the long-run, shifts in the AS curve are more likely since government policies, developments in technology and know-how, the output of human effort, and market forces will have longer to take effect.

In the next article, we discuss the classical concept of AS.