Consumer Spending Habits: Aggregate Supply

Aggregate Supply Sellers, like buyers, respond to incentives. How much they are willing to produce in a given year depends on their assessments of the profitability of selling their products. The amount sellers are willing and able to supply to product markets is influenced by the price of their products and such other considerations as wages, other input prices, and technology. In macroeconomic analysis we begin by isolating the influence of product prices on production decisions. The aggregate quantity supplied is the quantity of final products (measured by real GNP) that will be supplied by producers at a given price level. Aggregate supply is a relationship between the price level and aggregate quantity supplied. An aggregate supply curve shows the aggregate quantity supplied for each possible price level over a given period. When drawing an aggregate supply curve, we assume that all input prices and the general availability and quality of productive resources in the economy are fixed. We also assume that technology is given and does not advance over the period. An upward-sloping aggregate supply curve, illustrated in Box 5, implies that an increase in the price level will increase the aggregate of final products, measured by real GNP, that domestic business firms will produce. As was the case for aggregate demand, the shape of the aggregate supply curve cannot be as easily explained as that of a market supply curve for a particular item. A market supply curve slopes upward because higher prices imply greater opportunities for profit, thereby attracting new sellers to enter the market over the long run. When we discuss aggregate supply, the number of sellers and resources available during the year are more or less fixed, so it's not possible to explain the increase in output in terms of attraction of additional sellers or resources into production. However, there is reason to believe that profit opportunities from supplying more output do increase in the aggregate, at least over a period of a year, when the price level rises. Over a short period a higher price level increases the amount businesses receive from selling additional output, while input prices stay the same. Naturally, as product prices rise but input prices remain constant, opportunities arise for additional profit from producing more. This leads producers to produce more until the costs of additional output (this is the marginal cost of output) rise to match the higher prices. Costs of additional output eventually rise because firms must work their existing facilities more intensely and hire less experienced workers to produce more. As this occurs, unit costs of production tend to rise because of overuse of facilities and the lower skill and productivity of less experienced workers. If you've already studied microeconomics, you know that the marginal cost of output for a firm tends to increase as more output is supplied. In the graph in Box 5 the level of real GNP corresponding to potential real GNP is indicated on the horizontal axis. Recall that potential real GNP is the level of real GNP that would be produced if the economy were at full employment. As potential real GNP for the economy is approached, factories, offices, and other productive facilities are pushed beyond the levels at which the unit cost of production is at a minimum. The overall level of efficiency of operation is impaired. These factors contribute to the higher unit production costs that occur, even though input prices are constant. In addition, as an economy's potential real GNP is approached, businesses often have difficulty in obtaining all the input they require. To operate facilites around the clock, firms must use overtime labor, which is often difficult to obtain without paying bonuses. The aggregate supply curve becomes steeper as output increases because the costs of producing the additional units increase as potential real GNP is approached.2 Notice that the aggregate supply curve goes through the line corresponding to potential real GNP. The economy can produce more than the amount of final products corresponding to potential real GNP when the actual unemployment rate falls below the natural rate of unemployment. However, there is a physical limit to the amount of output that can be produced in a given year. As the economy surpasses potential real GNP, firms hire less experienced workers and work their plants around the clock. As this occurs, unit costs of production tend to soar. These higher costs are reflected in the steeply rising aggregate supply curve beyond the level of real GNP corresponding to the natural rate of unemployment. The aggregate supply curve eventually becomes vertical (see Box 5). The level of real GNP corresponding to that point is the physical limit of production for the economy for the year. At that point it is virtually impossible to obtain the labor and other inputs necessary to increase output any more.