Short-run and long-run aggregate supply

What SRAS is and why costs shift it, what LRAS shows about productive capacity and the classical and Keynesian views. Through the 2022 energy shock.

Inflation hit 11.1% in October 2022.

After Russia’s invasion of Ukraine in February 2022, gas and electricity prices soared. Energy is a cost for almost every firm, from bakeries heating ovens to factories and farms. UK consumer price inflation reached 11.1% in October 2022, the highest for about 41 years, while output stagnated in the second half of 2022.

Rising prices and weak output together: that is what happens when the supply side of the economy is hit.

Source: Office for National Statistics, Consumer price inflation (November 2022).

Aggregate supply.

Aggregate supply (AS) is the total output firms in an economy are willing and able to produce at each price level.

Short-run aggregate supply (SRAS) assumes the prices of inputs, such as wages and raw materials, are fixed. If the price level rises while costs stay put, producing becomes more profitable, so firms supply more: SRAS slopes up.

Long-run aggregate supply (LRAS) shows the economy’s productive capacity: the output it can produce when all resources are fully used. It depends on the quantity and quality of the factors of production and on technology, not on the price level.

Think first

The price of gas and electricity for businesses doubles.

Nothing else changes yet.

What happens to firms’ willingness to produce at the current price level?

Higher costs make every level of output less profitable at the existing price level, so firms supply less. Short-run aggregate supply shifts left: the cost-push shock behind the inflation of 2022.

Step by step

1. SRAS slopes up: with input costs fixed in the short run, a higher price level makes extra output profitable.

2. Anything that raises firms’ costs shifts SRAS to the left (up): higher wages, energy and raw material prices, higher indirect taxes or a weaker pound making imported inputs dearer. That is what happened in 2022.

   Check: Which would shift SRAS to the left?

   Higher input costs reduce what firms will supply at every price level.

3. Falling costs shift SRAS to the right: cheaper energy or raw materials, lower indirect taxes or subsidies, a stronger pound making imports cheaper or short-run productivity gains.

4. The classical view of LRAS is vertical at the economy’s productive capacity: in the long run, output depends on resources and technology, not on the price level. More or better resources, or better technology, shift LRAS right. This is the same as the PPF shifting outwards.

   Check: Which would shift LRAS to the right?

   Better-skilled workers raise the economy’s productive capacity. Short-lived cost changes shift SRAS, not LRAS.

5. Keynesians see the long run differently. Start with an economy in a deep recession.

   Check: An economy is in a deep recession, with many workers and machines idle. Firms start to raise output. What happens to their costs and prices?

   With lots of spare capacity, firms can take on unemployed workers and use idle machines without bidding up wages or other costs, so prices hardly change.

6. The Keynesian view of LRAS has three parts. With lots of spare capacity, firms can raise output without raising prices: flat. As the economy nears full capacity, bottlenecks and shortages push up costs: rising. At full capacity, Yfe, output cannot rise further: vertical.

What your diagram must show

• Axes labelled price level and real GDP
• A flat section at low output, labelled spare capacity
• A rising section, labelled bottlenecks
• A vertical section at full capacity, labelled Yfe

A common mistake

A rise in oil prices raises firms’ costs: it shifts SRAS left. It does not reduce the economy’s productive capacity, so LRAS does not move.

Exam question

Explain the difference between a shift in SRAS and a shift in LRAS, with an example of each.

Model answer

Short-run aggregate supply shows the output firms will produce at each price level when input prices, such as wages and raw materials, are fixed. SRAS shifts when firms’ costs change. For example, the sharp rise in energy prices in 2022 raised costs for almost all firms, shifting SRAS to the left: less was supplied at every price level.

Long-run aggregate supply shows the economy’s productive capacity, which depends on the quantity and quality of the factors of production and on technology. LRAS shifts when capacity changes. For example, investment in education and training raises the productivity of the workforce, shifting LRAS to the right.

So SRAS shifts reflect changes in costs, which may be temporary, while LRAS shifts reflect lasting changes in what the economy can produce.

[Diagram: SRAS1 and SRAS2 to the left; LRAS1 and LRAS2 to the right.]