No Such Thing as a Free Lunch: Principles of Economics (Part 136)

I don't go to the beach. There is no value in going to the beach. If I did go I would probably read economics books.

Esther Duflo

Aggregate Demand, Aggregate Supply, and Inflation

(Part E)

by

Charles Lamson

Shifts of the Short-Run Aggregate Supply Curve

Just as the aggregate demand curve can shift (See part 133), so to can the aggregate supply (price/outlet response) curve. Recall the individual firm behavior we just considered in part 135 in describing the shape of the short-run curve. Firms with the power to set prices choose the price/output combinations that maximize their profits. Firms in perfectly competitive industries choose the quantities of output to supply at given price levels. The AS curve traces out those price/output responses to economic conditions.

Anything that affects these individual firm decisions can shift the AS curve. Some of these factors include cost shocks, economic growth, stagnation, public policy, and natural disasters.

Cost Shocks Firms decisions are heavily influenced by costs. Some costs change at the same time the overall price level changes, some costs lag behind changes in the price level, and some may not change at all. Changes in costs that occur at the same time that the price level changes are built into the shape of the short-run AS curve. For example, when the price level rises, wage rates might rise by half as much in the short run. (This could happen if half of all wage contracts in the economy had cost-of-living increase clauses and half did not.) The shape of the short-run AS curve would reflect the response.

Sometimes cost changes occur that are not the result of changes in the overall price level---for example, the cost of energy. During the fall of 1990, world crude oil prices doubled from about $20 to $40 a barrel. Once it became clear the Persian Gulf War would not lead to the destruction of the Saudi Arabian oil fields, the price of crude oil on world markets fell back to below $20 per barrel. In contrast, in 1973 to 1974 and again in 1979, the prices of oil increased substantially and remained at a higher level. Oil is an important input in many firms and industries, and when the price of a firm's inputs rises, Firms respond by raising prices and lowering output. At the aggregate level, this means an increase in the price of oil (or a similar cost increase) shifts the AS curve to the left, as in Figure 7(a). A leftward shift of the AS curve means a higher price level for a given level of output.

FIGURE 7 Shifts of the Aggregate Supply Curve

Economic Growth Economic growth shifts the AS curve to the right. Recall that the vertical part of the short-run AS curve represents the economy's maximum (capacity) output. This maximum output is determined by the economy's existing resources and the current state of technology. If the supply of labor increases or the stock of capital grows, the AS curve will shift to the right. The labor force is expected to grow naturally with an increase in working-age population, but it can also increase for other reasons. Since the 1960s, for example, the percentage of women in the labor force has grown sharply. This increase in the supply of women workers has shifted the AS curve to the right. 

Immigration can also shift the AS curve. During the 1970s, Germany, faced with a serious labor shortage, opened its borders to large numbers of "guest workers," largely from Turkey. The United States has recently experienced significant immigration, legal and illegal, from Mexico, from Central and South American countries, and from Asia. Increases in the stock of capital over time and technological advances can also shift the AS curve to the right. We will discuss economic growth in more detail in a later post.

Stagnation and Lack of Investment The opposite of economic growth is stagnation and decline. Over time, capital deteriorates and eventually wears out completely if it is not properly maintained. If an economy fails to invest in both public capital (sometimes called infrastructure) and private capital (plant and equipment) at a sufficient rate, the stock of capital will decline. If the stock of capital declines, the AS curve will shift to the left.

Public Policy Public policy can shift the AS curve. In the 1980's, for example, the Reagan administration put into effect a form of public policy based on supply-side economics. The idea behind these supply-side policies was to deregulate the economy and reduce taxes to increase the incentives to work, engage in entrepreneurial activity, and invest. The main purpose of these policies was to shift the AS curve to the right. (We discuss supply-side economics in a later post.)

Weather, Wars, and Natural Disasters Changes in weather can shift the AS curve. A severe drought will reduce the supply of agricultural goods; the perfect mix of sun and rain will produce a bountiful harvest. If an economy is damaged by war or natural disaster, the AS curve will shift to the left. Whenever part of the resource base of an economy is reduced or destroyed, the AS curve shifts to the left. Figure 8 shows some factors that might cause the AS curve to shift. 

FIGURE 8

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 542-543*

end