Long Run Aggregate Supply (LRAS) (Cambridge (CIE) A Level Economics): Revision Note

The relationship between short-run and long-run AS

• Short run aggregate supply (SRAS) is influenced by changes in the costs of production or productivity

  • Short run refers to the time period where at least one factor of production is fixed

• Long run aggregate supply (LRAS) is influenced by a change in the productive capacity of the economy

  • Productive capacity is affected by changes to the quantity or quality of the factors of production

    • When production capacity changes, it is equivalent to a shift inwards/outwards of the production possibilities frontier (PPF)

• Long-term economic growth requires the productive capacity to increase

An introduction to long-run aggregate supply (LRAS)

• The long-run aggregate supply (LRAS) represents the potential capacity of an economy's factors of production

• Any factor that changes the quantity or quality of a factor of production will impact the long-run aggregate supply (LRAS) of an economy

  • This corresponds to an outward or inward shift of the potential output of an economy on the production possibilities diagram

• The diagram above represents the Classical Economics view of the long-run aggregate supply

  • The Keynesian view is contrasted further down the page

Diagram analysis

• Using all available factors of production, the long-term output of this economy (LRAS) occurs at Y_FE

  • At Y_FE, all of the resources available in the economy are fully employed (utilised)

  • At Y_FE, the position of the vertical long-run AS curve represents the normal capacity level of output in the economy 

• The economy is initially in equilibrium at the intersection of AD and LRAS₁ (AP₁, Y_FE)

• An outward shift of a country’s LRAS curve means that its productive capacity has increased 

  • This fundamental expansion of the economy can be seen in the shift from LRAS₁ → LRAS₂

  • Underlying economic growth is represented by a rightward shift in the long-run AS curve 

• The following factors will shift the entire LRAS curve outward and increase the potential output of the economy

  • An improvement in the quality of the factors of production 

    • E.g. An increase in productivity (output per unit of input) 

  • An increase in the quantity of the factors of production 

The Keynesian aggregate supply curve

• Keynes believed that the long-run aggregate supply curve (LRAS) was more L shaped

  • Supply is elastic at lower levels of output as there is a lot of spare production capacity in the economy

    • Struggling firms will increase output without raising prices

  • Supply is perfectly inelastic (vertical) at a point of full employment (Y_FE) of all available resources

    • The closer the economy gets to this point, the more price inflation will occur as firms compete for scarce resources

• The Keynesian view believes that an economy will not always self-correct and return to the full employment level of output (YFE)

  • It can get stuck at an equilibrium well below the full employment level of output e.g. Great Depression

• The Keynesian view believes that there is role for the government to increase its expenditure so as to shift aggregate demand and change the negative 'animal spirits' (emotions) in the economy

Diagram analysis: the three sections of the Keynesian LRAS

• Section 1 - highly elastic:

  • the economy has significant spare capacity and high unemployment; firms can increase output by bringing idle resources back into production without bidding up factor prices - the price level remains stable as real GDP rises

• Section 2 - upward sloping:

  • the economy approaches full capacity; bottlenecks begin to emerge as some resources become scarce, firms must pay higher factor prices to attract them, and unit costs rise - output increases but only alongside a rising price level

• Section 3 - vertical at YFE:

  • the economy is at full employment of all resources; no additional output is possible regardless of the price level - any increase in AD beyond this point is purely inflationary

The determinants of long-run Aggregate Supply

• Any factor that changes the quantity or quality of a factor of production will impact the long-run aggregate supply (LRAS) of an economy: 

  • This corresponds to an outward or inward shift of the potential output of an economy on the production possibilities diagram

• The following factors will shift the entire LRAS curve outward and increase the potential output of the economy

1. Technological advances: these often improve the quality of the factors of production, e.g. development of metal alloys

2. Changes in relative productivity: process innovation often results in productivity improvements, e.g. moving from labour-intensive car production to automated car production

3. Changes in education and skills: over time, this increases the quality of labour in an economy

4. Changes in government regulations: these can improve the quantity of the factors of production. e.g. deregulation of fracking (extracting oil from shale deposits) increased oil reserves

5. Demographic changes and migration: a positive net birth rate or positive net migration rate will increase the quantity of labour available

6. Competition policy: regulating industries so as to prevent monopoly power results in more firms supplying goods/services in an economy and this increases the potential output of an economy

7. The institutional structure of the economy: Good contract laws and an efficient banking system help the economy run smoothly, promoting long-term growth, and pushing the production possibilities and LRAS curve to the right.

   • During the financial crisis starting in 2007, banks' inability to support businesses shifted LRAS to the left, making the 2008-2009 recession worse and longer 

Improving the quality and quantity of factors of production