Introduction

In the last article we explored the classical concept of aggregate supply (“AS”). Classical economists distinguish between aggregate supply in the short-run and long-run.

In the short-run, they consider that changes in aggregate demand (“AD”) can have an impact on the output of an economy. However, in the long-run, classical economists think the shape of the aggregate supply curve is vertical, and changes in aggregate demand do not have an effect on output, only price.

In this article, we discuss the Keynesian concept of AS. The points we examine in particular are:

1. The concepts and of spare capacity and diminishing returns, which are important to understanding Keynesian theories of AS;
2. What Keynesian economists think the long-run AS (“LRAS”) curve looks like; and
3. Interactions between the Keynesian LRAS curve and AD, and its impact on GDP.

Generally speaking, Keynesian economists do not distinguish between the long-run and short-run in AS. This is because they do not consider that the prices of all factors of production (particularly wages) are fully variable over time - which we discuss below. In this article, we therefore only refer to LRAS.

Spare capacity and diminishing returns

Before we look at what Keynesian economists think the LRAS curve looks like, it’s important to understand the concepts of spare capacity and diminishing returns.

Spare capacity - Classical economists think that, in the long-run, the free market will work to ensure that supply equals demand and the market clears to the natural equilibrium point. This applies for all factors of production (land, labour, capital and entrepreneurship). Put another way, they consider that in the long-run an economy will operate at full capacity.

However, Keynesian economists dispute this. They consider that, at various stages of an economic cycle, there may be spare capacity within an economy i.e. a surplus of AS at given price levels. This means that AD can increase, and an economy can increase its output with little or no impact on price.

They consider that this applies, in particular, within labour markets. At certain wage levels, Keynesian economists think there may be more people willing and able to work than the amount of labour actually demanded i.e. there is an excess supply of labour at those wage levels. This is likely to be the case where there has been a fall in AD / a demand deficient recession.

This is because, they say, wages are sticky downwards. This means that, when there has been a fall in AD resulting in lower demand for workers, there are legal or social reasons which mean that wages cannot fall beyond a certain point to the true equilibrium level. Legal reasons could include minimum wage, and rules regarding redundancy pay. Social reasons could include pressures firms might face if they tried to lower wages for current workers – such as from trade unions.

Therefore, at the wage-level which is higher than equilibrium, there may more workers willing and able to work than are actually demanded i.e. there is excess supply of labour / spare capacity. This is demonstrated in figure 1 below.

SL1 is the supply curve for labour. DL1 is the demand curve for labour. They intersect at point E, with W1 representing the wage level of the economy, and Q1 representing the quantity of labour employed.

If demand for labour fell – e.g. because of a fall in AD in the economy, meaning fewer goods are demanded and fewer workers are needed to produce those goods – this would result in an inward shift in the demand curve for labour, from ADL1 to ADL2.

If market forces were unchecked, this would result in a new equilibrium point, E2, and the wage level would fall to W2 and quantity of labour employed to Q2. However, due to social and legal restrictions, Keynesian economists think that wages will not be able to fall beyond a certain level – for example, W3 in figure 1.

At this level, there is a difference between the amount of labour demanded and the amount of labour supplied – see QD3 and QS3. This gap between labour demanded and labour supplied is the spare capacity for labour – there are more people willing and able to work at this wage level than the amount demanded.

Importantly, the demand for labour can increase up to point E3 without there being an increase in wages.

Further, if employment is not at full capacity and there has been a decrease in AD, other factors of production may also not be used to fully capacity e.g. a factory may only run 1 of its machines rather than 2.

Where there is spare capacity, if AD increases, firms can increase their output without an increase in the marginal cost of production i.e. the price to produce each unit of goods / services does not increase (there is no disproportionate increase in costs of production) and therefore the overall price for those goods / services remains the same.

Finally, in the real world, there are other inefficiencies within markets which mean that they do not clear. For example, the perfect market model assumes perfect mobility of the factors of production (land, labour, capital, entrepreneurship) i.e. they can move freely within the market and can be used for whatever purpose an economy requires. However, this does not hold true. For example, workers have different skills and so may not be able to move freely between sectors and industries. We discuss this and other market inefficiencies in further detail in our article on Interventionist Supply-Side Policies.

Diminishing returns - If AD continues to increase and firms continue to ramp up production, at some point firms will get close to full capacity and will suffer from diminishing returns. This means that it will cost more to produce each additional unit than the last – economists say that the marginal costs of production increase, and this will feed into prices and push them up.

Costs may increase because of shortages of factors of production (land, labour, capital, and entrepreneurship), meaning firms have to pay more for them. Once an economy reaches full capacity, it may experience bottlenecks in certain factors of production, and it therefore cannot produce any more.

Shape of Keynesian LRAS curve

Keynesian economists think that the LRAS curve for an economy is as shown in figure 2. Whether a shift in AD will have an impact on the level of output (GDP) will depend upon where along the LRAS curve AD intersects – or, put another way, where in a cycle an economy is (see our article on Business Cycles).

In Section A, a shift in the AD curve can have an impact on output without influencing price at all. At this point, there is lots of spare capacity within an economy – unused labour that would be willing to work at the current price level, unused capital (e.g. machinery), and unused land (including natural resources). Firms can use this spare capacity to increase production in response to an increase in AD without causing an overall increase in prices.

In section B, a shift in the AD curve would have an impact on both price and output. At this point, there is some spare capacity within the economy, but firms are ramping up production towards full capacity and are suffering from diminishing returns, causing an increase in price.

In section C, the LRAS curve is vertical – just like the classical LRAS curve. At this point, an economy is at full capacity and a shift in AD will only have an impact on price, not output.

Impact on policy

Considering the above, Keynesian economists believe that an economy can grow its GDP through a combination of demand and supply side policies depending on where AD intersects the LRAS curve.

If AD intersects the LRAS curve in section C, an economy can grow its output (GDP) by boosting AD (without increasing overall price levels). An economy could use demand-side policies to facilitate this.

However, if AD intersects the AS curve in section C, there would need to be an increase in AS to grow output (GDP). As discussed in our Introduction to Aggregate Supply, AS will increase if the quantities / prices and quality of the factors of production change as follows:

1. Quantities increase (and therefore prices decrease);
2. Quality increases (i.e. effectiveness in production increases relative to overall costs).

An economy could use supply-side policies to facilitate this. For completeness, in figure 3 below we show examples of shifts in the Keynesian LRAS curve.

Indicators that an economy has plenty of spare capacity are high unemployment and/or low inflation.

Indicators that an economy is operating at close to full capacity are low unemployment and high inflation.

Conclusion

You should now understand the Keynesian theory of LRAS, including the concepts of spare capacity and diminishing returns, and what the Keynesian LRAS curve looks like.

In summary, we learned that:

• Spare capacity within an economy is caused by wages not being able to fall to the true equilibrium point following a demand deficient recession. At a wage level that is higher than equilibrium, there is an excess supply of labour i.e. spare capacity. AD can increase, and firms can recruit to fulfil the increased demand without increasing wages. A fall in AD can also result in other resources being unused;
• Diminishing returns occur when an economy ramps up production to full capacity. This means that it costs more to produce each additional unit i.e. the marginal costs increase. This could be due to shortages in factors of production. Once a country reaches full capacity, it cannot produce any more and an increase in AD will only result in an increase in price;
• The Keynesian LRAS curve varies in shape depending upon what stage in the business cycle an economy is. Depending on this, a country may be able to grow output (GDP) by using either supply or demand side policies, or a combination of both.