Question

Your study partner is confused by the upward-sloping short-run aggregate supply curve and the vertical longrun aggregate supply curve. How would you explain this?

Short answer

The key difference between the SRAS and LRAS curves is that the SRAS curve shows a positive relationship between price level and output in the short run, with firms responding to changing price levels by adjusting production. In contrast, the LRAS curve represents the economy's potential output in the long run, which is independent of the price level and determined by the economy's resources, technology, and institutional structures.

Step-by-step solution

Introduce the Aggregate Supply curve

The aggregate supply curve shows the total quantity of goods and services that firms in an economy are willing to produce at different price levels. It demonstrates the relationship between the overall price level and the total output an economy produces. There are two types of aggregate supply curves: short-run and long-run.

Explain the Short-Run Aggregate Supply curve

The short-run aggregate supply (SRAS) curve is upward-sloping, which shows that in the short run, the quantity of goods and services firms are willing to produce increases as the overall price level rises. This happens because, in the short run, some inputs or factors of production (e.g., labor, capital) remain fixed, while others can be adjusted. As prices rise, firms increase production because it becomes more profitable to produce goods and services. Higher prices cover their higher costs (such as wages and raw materials) and contribute to increased revenue. Inflation or price level increases can also be due to a larger quantity of money, higher production costs, or higher demand for goods and services.

Explain the Long-Run Aggregate Supply curve

The long-run aggregate supply (LRAS) curve is vertical, meaning that in the long run, the quantity of goods and services firms are willing to produce does not depend on the overall price level. This happens because, in the long run, all inputs or factors of production are variable, and firms can adjust their production capacity. Additionally, the economy reaches a point where it is producing at its full potential output (also known as potential GDP), and this output level is determined by the economy's resources, technology, and institutional structures. In the long run, changes in the price level do not affect this potential output.

Compare SRAS and LRAS

The key difference between the SRAS and LRAS curves is that SRAS shows a positive relationship between price level and output in the short run, while LRAS shows the economy's potential output in the long run, which is independent of the price level. The upward-sloping SRAS curve represents the fact that firms respond to changing price levels by adjusting production in the short run, while the vertical LRAS curve represents the economy's potential output that is not influenced by price level changes in the long run.

Summarize the explanation

In summary, the upward-sloping short-run aggregate supply curve demonstrates that firms are willing to produce more goods and services as the price level increases in the short run, while the vertical long-run aggregate supply curve shows that the economy's potential output level is independent of price level changes in the long run. The SRAS curve captures the short-term adjustments firms make in response to changing prices, while the LRAS curve represents the economy's long-term potential output given its resources, technology, and institutional arrangements.

Key concepts

Short-Run Aggregate Supply (SRAS)

The Short-Run Aggregate Supply (SRAS) curve reflects the idea that production in the economy can respond to changes in price levels temporarily. In the short run, some factors of production, such as labor and machinery, are fixed, but others, like materials or energy, can be variable. This means that if the overall price level in an economy increases, firms can increase their production to take advantage of the higher prices. They do this because the higher prices can cover their costs, including fixed costs and variable input costs.

The SRAS is upward sloping because as prices rise, production becomes more profitable for firms. The immediate increase in demand leads to more production and a higher output. However, this is only sustainable in the short term, as eventually, constraints like fixed capital and labor contracts play a role, limiting how fast and how much output can be increased.

Long-Run Aggregate Supply (LRAS)

In contrast, the Long-Run Aggregate Supply (LRAS) curve is vertical. This depicts that, in the long run, the total output of an economy is determined by its resources, technology, and institutional structures rather than the price level. In the long run, all factors of production are variable, meaning firms can adjust their labor and capital to achieve the maximum production possible.

The LRAS curve represents an economy's potential GDP, showing how the maximum possible production level is independent of changes in the price level. Economy factors that define this are the quantity and quality of labor, the stock of capital goods, technology, and the efficiency of production. Thus, shifts in this curve depend on long-term changes in these factors, not on short-term fluctuations in price levels.

Potential GDP

Potential GDP is the maximum level of output an economy can produce when all resources are used efficiently. This is considered the long-term trend of output, around which short-term deviations occur. It is represented where the LRAS curve is positioned vertically.

Potential GDP is determined by the economy's resources such as labor and capital, and its technology, and is unaffected by price level changes in the long run. It reflects the most that an economy can sustainably produce without causing inflationary pressure. If actual GDP surpasses potential GDP, it could lead to inflation, while if it falls short, it indicates underutilized resources and unemployment.

Price Level

Price level refers to the average of current prices across the entire spectrum of goods and services produced in the economy. It is a key factor in determining the SRAS but not the LRAS.

In the short run, if the price levels increase, firms are motivated to increase their production since higher prices can improve profitability. This results in an upward movement along the SRAS curve. However, in the long run, price level adjustments do not affect the economy's potential output as depicted by the LRAS.

Factors of Production

The factors of production are the resources used to produce goods and services in the economy. These include labor, capital, land, and entrepreneurship. In the short run, some of these factors are fixed, which affects the economy's output level as prices change. For example, labor contracts or fixed capital investments might limit how quickly a firm can increase production.

In the long run, all factors of production become variable. Firms can invest in new machines, hire new workers, or advance their technological capabilities. This flexibility allows the economy to adjust and reach its potential output, as depicted by the LRAS curve, independent of short-term price changes.