Long-run Aggregate Supply (LRAS) (AQA A Level Economics)

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

Diagram: Shift in the Long-run Aggregate Supply (LRAS)

• 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 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

Institutional Factors & Long-run Aggregate Supply

• Institutional structures refer to the established frameworks, organisations, regulations, norms, and practices within a society that govern the behaviour of economic agents

  • These structures encompass formal institutions, such as government bodies, legal systems, and regulatory agencies (e.g Competition & Markets Authority), as well as informal institutions (e.g. Confederation of British Industry)

  • They provide the framework within which economic activities take place, allocate resources, and govern the distribution of wealth and opportunities within a society

  • They define the rules of the game, establish property rights, enforce contracts, and provide the necessary infrastructure for economic growth 

• Institutional structures exert a significant influence on long-run aggregate supply by shaping the economy's productive capacity, technological progress, and efficiency

  • Policies that promote labour market flexibility, financial stability, property rights protection, education, infrastructure development, and innovation are essential for expanding LRAS

  • By addressing institutional weaknesses and implementing reforms that support a conducive environment for investment, entrepreneurship, and productivity enhancement, policymakers can contribute to sustainable LRAS growth

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

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

• The economy is initially in equilibrium at the intersection of AD₁ and LRAS (P₁, Y_FE)

• A slowdown reduces output from AD₁→AD₂ and creates a recessionary gap Y₁-Y_FE

  • The economy may reach a point where average prices stop falling (P2), but output continues to fall

  • This economy may not self-correct to Y_FE for years

  • The low output leads to high unemployment and low confidence in the economy

    • This stops further investment and further reduces consumption

• Keynes argued that this was where governments needed to intervene with significant expenditures, e.g. Roosevelt's New Deal; and the response to the financial crisis of 2008; and the response to Covid in 2020

The Relationship Between Short-run & 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 changed 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