Long-Run Aggregate Supply

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Definition of Long-Run Aggregate Supply:

The long-run aggregate supply is an economy’s production level (RGDP) when all available resources are used efficiently. It equals the highest level of production an economy can sustain. It is also referred to as an economy’s natural level of output because in the long-run an economy that is in a recession or overheated returns to its long-run aggregate supply. 

Detailed Explanation:

When economists refer to the long-run they are assuming that all prices are flexible and all inputs are variable. This includes input prices such as labor and raw materials and the prices of the final goods and services. In the long-run an economy’s potential is limited by its factors of production which includes its natural resources, people, technology, entrepreneurs, and capital.  Note that price is not mentioned. In the long-run, production is independent of the price level. In other words, whether the price level increases or decreases, the long-run aggregate supply is unchanged.

An economy’s production is usually measured by its real gross domestic product (RGDP). The long-run aggregate supply (LRAS) curve is vertical because the price level has no bearing on the economy’s long-run potential. The LRAS curve intersects the horizontal axis where the factors of production are used in the most efficient manner, which is called the full employment output or the natural level of output. On the graph below this is labeled as QLR.

Graph 1
Long-Run Aggregate Supply chart

Why is long-run production independent of the price level? 

Production is driven by profits, so we must show that profits do not increase in the long-run following an increase in the price level to prove long-run production is independent of the price level.

The French company, Janet’s Newspaper Delivery Service illustrates this point. Assume inflation is ten percent, so Janet increases her price by ten percent. The cost of her papers, employees’ wages, rent, gasoline, and all other costs also increase by the general price level, or ten percent. The table below shows the resulting profits before and after the increase in the price level. Janet’s profit increases ten percent, but she is no better off than before because all the prices in the economy have increased ten percent. Her purchasing power is unchanged. Therefore, there is no incentive for Janet to increase her supply, i.e. the number of papers she sells. If we extend this specific example to every business in every sector of the economy, we can understand how when all prices increase or decrease by the same percentage, the long-run aggregate supply is unaffected.

Profit and Long-Run Aggregate Supply Graph

How does the economy return to long-run equilibrium when it is in a recession?

All prices and output are flexible in the long-run. When something triggers a drop in the economy’s aggregate demand, the price level and short-term output fall – until the prices of all inputs and outputs adjust. Assume a national financial crisis lowers the demand for Janet’s delivery service and she is forced to lower her prices ten percent. Initially, she is very reluctant to decrease the amount she pays her employees, and gasoline prices remain unchanged. Profits decline, so she is willing to supply fewer newspapers at the lower price. However, in the long-run, wages adjust. Some employees may accept a ten percent reduction in pay. Others may be let go since she sells fewer newspapers. The reduction in her costs boosts profits so she is again willing to provide the same number of newspapers as before. The economy has returned to the long-run aggregate supply, but at a lower price level. This is illustrated with the series of graphs below.

Initially the economy is operating in a long-run equilibrium where the short-run aggregate supply (SRAS), LRAS and aggregate demand (AD) are in equilibrium and the resulting price level is PL1 and QLR is the RGDP. 

Graph 2A
Long Run Equilibrium Chart

Assume a financial crisis triggers a drop in the aggregate demand from AD1 to AD2, as shown on Graph 2B. Shortly after, companies see the demand for their goods and services decrease. Output would fall to Q1 if the price level remained at PL1, but companies respond by lowering their prices hoping to increase the quantity demanded for the good or service they offer. Because they are unable to reduce all their costs, production still falls, but not to the same degree as it would without reducing prices. In the short-run, there is movement along the SRAS from (PL1, QLR) to (PL2, QSR). A short-term equilibrium is reached where the price level is PL2 and production falls to QSR.

Graph 2B
Financial Crisis Chart

At this point some employees have lost their jobs, and the demand for other inputs has decreased because production in the economy has fallen. All producers are benefiting from a lower cost because the decrease in demand for inputs has resulted in a lower input cost, which causes in a rightward shift of the economy's short-run aggregate supply curve to SRAS2. Employees are rehired, but at a lower wage, which in theory they do not mind since the economy’s price level has also decreased. In the long-run all prices in the economy decrease by the same percentage. Eventually, long-run equilibrium is reached where the output returns to the natural level of output, QLR, and the price-level drops to PL3. This illustrates how an economy recovers to produce its long-run aggregate supply following a financial crisis. 

Graph 2C
Return to Long Run Equilibrium Chart

How does an economy return to the long-run equilibrium when the economy overheats? 

When an economy is operating at its long-run equilibrium all resources are being used at the full employment or natural production rate. Resources are not pushed beyond the point where prices are dramatically impacted. 

Economies can be compared to long distance runners. Long distance runners are most efficient when they pace themselves. They can sprint for short periods but tire and ultimately hurt their performance if they do so for too long. Like long distance runners, an economy is most efficient when it paces itself. For short periods, an economy can operate beyond its long-run aggregate supply. Economists use similar terms such as “tired,” “overheated,” and “spent” to describe an economy in this phase. During these periods, manufacturers may defer maintenance to continue meeting demand. Workers may tire and become less productive when working overtime for extended periods. Companies raise prices to reduce their quantity demanded. Initially profits rise, but in the long-run wages will increase because the demand for workers has increased and employees work overtime. Raw materials also become more expensive because of mounting demands. Eventually, the price of all inputs increase. The higher costs return profits to normal and output is cut back to the long-run aggregate supply, but the price level has increased. This is illustrated in steps on the graphs below.

Let us return to when the economy is operating in a long-run equilibrium. The short-run aggregate supply (SRAS), LRAS and aggregate demand (AD) are in equilibrium and the resulting price level is PL1 and QLR is the RGDP. 

Graph 3A
Long Run Equilibrium Chart

Assume an overheated economy increases the aggregate demand from AD1 to AD2. Shortly after companies see the demand for their goods and services increase. Output would increase to Q1 if the price level remained at PL1, but companies respond by increasing their prices hoping to take advantage of the increase in demand. However, their marginal costs are also increasing. In the short-run, there is movement along the SRAS from (PL1, QLR) to (PL2, QSR). Companies increase production and increase their prices to meet the increase in demand. A short-run equilibrium is reached where the price level is PL2 and production increases to QSR.

Graph 3B
Overheated Economy Chart

At this point employees are working overtime and more are being hired. Suppliers are having trouble meeting the company’s increased demand. The forces of an increase in demand and a decrease in the available supply of inputs has pushed the production cost higher, which shifts the short-run aggregate supply curve (SRAS) to the left, to SRAS2. Eventually a new long-run equilibrium is reached, resulting in the same production as before, QLR, but a higher price level, PL3. This illustrates how an economy cannot sustain production beyond its long-run equilibrium. 

Graph 3C
Return to Long Run Equilibrium Chart

Policy Implications

Increasing its long-run aggregate supply is the only way an economy can achieve long-term economic growth. Some policies that influence an economy’s long-run aggregate supply include:

Labor – Immigration policies affect the number of workers available, thereby an economy’s potential. Policies that discourage immigration or encourage emigration reduce an economy’s long-run aggregate supply. Improving education increases a labor force’s productivity. Policies that encourage labor participation increase the work force, thereby increasing the long-run aggregate supply. 

Entrepreneurs – Governments that provide a hospitable environment for entrepreneurs will increase their long-run aggregate supply. 

Capital – Tax policies favorable to capital investment improve productivity, which increases a country’s production potential.

Technology – Technology improves productivity, which increases a country’s production potential. 

Dig Deeper With These Free Lessons:

Aggregate Supply - Relating Inflation and Production
Aggregate Supply and Demand - Macroeconomic Equilibrium
Fiscal Policy - Managing an Economy by Taxing and Spending
Factors of Production - The Required Inputs of Every Business

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