Aggregate Supply Explained: What It Is, How It Works

What Is Aggregate Supply?

Aggregate supply, also known as total output, is the total supply of goods and services produced within an economy at a given overall price in a given period. It is represented by the aggregate supply curve, which describes the relationship between price levels and the quantity of output that firms are willing to provide. Typically, there is a positive relationship between aggregate supply and the price level.

Aggregate Supply Explained

Rising prices are typically an indicator that businesses should expand production to meet a higher level of aggregate demand. When demand increases amid constant supply, consumers compete for the goods available and, therefore, pay higher prices. This dynamic induces firms to increase output to sell more goods. The resulting supply increase causes prices to normalize and output to remain elevated.

Changes in Aggregate Supply

A shift in aggregate supply can be attributed to many variables, including changes in the size and quality of labor, technological innovations, an increase in wages, an increase in production costs, changes in producer taxes, and subsidies and changes in inflation. Some of these factors lead to positive changes in aggregate supply while others cause aggregate supply to decline. For example, increased labor efficiency, perhaps through outsourcing or automation, raises supply output by decreasing the labor cost per unit of supply. By contrast, wage increases place downward pressure on aggregate supply by increasing production costs.

Aggregate Supply Over the Short and Long Run

In the short run, aggregate supply responds to higher demand (and prices) by increasing the use of current inputs in the production process. In the short run, the level of capital is fixed, and a company cannot, for example, erect a new factory or introduce a new technology to increase production efficiency. Instead, the company ramps up supply by getting more out of its existing factors of production, such as assigning workers more hours or increasing the use of existing technology.

In the long run, however, aggregate supply is not affected by the price level and is driven only by improvements in productivity and efficiency. Such improvements include increases in the level of skill and education among workers, technological advancements, and increases in capital. Certain economic viewpoints, such as the Keynesian theory, assert that long-run aggregate supply is still price elastic up to a certain point. Once this point is reached, supply becomes insensitive to changes in price.

Example of Aggregate Supply

XYZ Corporation produces 100,000 widgets per quarter at a total expense of $1 million, but the cost of a critical component that accounts for 10% of that expense doubles in price because of a shortage of materials or other external factors. In that event, XYZ Corporation could produce only 90,909 widgets if it is still spending $1 million on production. This reduction would represent a decrease in aggregate supply. In this example, the lower aggregate supply could lead to demand exceeding output. That, coupled with the increase in production costs, is likely to lead to a rise in price.