ECON2: The National Economy

2.8 Determinants of Long-Run Aggregate Supply

How easy is it to increase supply in the long-run?

2.8 What you need to know

The concept of long-run aggregate supplyThe determinants of the long-run aggregate

supply curveThey Keynesian aggregate supply curveThe institutional structure of the economyThe role of the banking system in the

economy

2.8 You should be able to:

Define long-run aggregate supplyExplain and analyse the determinants of long-run aggregate

supplyIllustrate the effects of changes in long-run aggregate supply on a

diagramUnderstand why the long-run aggregate supply curve is assumed

to be verticalUnderstand and explain the Keynesian long-run aggregate supply

curveUnderstand the importance of the institutional structure of the

economyUnderstand and explain the role of the banking system in

providing business investment funds

The Difference Between Short and Long-RunRecap. In the short-run, all factors of production are fixed, with the exception of labour which can be hired to cover increases in aggregate demand In the long-run, all factors of production are variable and can be increased over time In effect, long-run aggregate supply represents the maximum possible output an economy can produce as determined by its available land, labour, capital and entrepreneurial resources

The Long-Run Aggregate Supply Curve

Price Level

Real National Output

LRAS

P

Y

This is known as the classical view of long-run aggregate supply.

Y represents the maximum capacity of the economy to produce goods and services i.e. there is full employment and all resources are being used efficiently.

Factors Affecting LRAS (1)

Long-run aggregate supply can shift when there is a change in the quantity and/or quality of the factors of production

Land If additional land for production becomes available, or new

primary raw materials are discovered or become available, the productive potential of the economy will improve and LRAS will increase

Labour If there is an increase in the size of the labour force, then it

might be expected that output will increase If there is an increase in the quality of the labour force e.g.

through training and education then efficiency and productivity is enhanced and LRAS will increase

If there is improved occupational or geographical mobility of labour this gives firms more flexibility in production

Factors Affecting LRAS (2)

CapitalAn increase in the quantity, quality and productivity of

capital will boost LRASThis can often arise from improvements in technology and

improved research and developmentEntrepreneurship

Improved incentives to set up new businesses, or invest in the development of new goods and services, can lead to a boost in LRAS

And....Government Intervention Governments will often use regulatory frameworks to

improve the level of competition in different markets If successful, then greater competition can drive efficiency

gains amongst firms as they strive to maximise their profits

Shifts of the LRAS Curve

Price Level

Real National Output

LRAS

P

YY2 Y1

An increase in the quantity and/or quality of factors of production will shift LRAS from LRAS to LRAS1.

LRAS2 LRAS1

A decrease in the quantity and/or quality of factors of production will shift LRAS from LRAS to LRAS2.

For each of the following examples, identify the impact on LRAS. Will there be an increase or decrease in LRAS?

Impact Increase or Decrease?

The government introduces new immigration laws to limit the ability of migrant workers to seek employment in the UK

The government introduces tax breaks for companies that invest a portion of their profits in research and development

An extra £2bn is made available for education and training

The government raises the retirement age to 70

Pressure groups successfully block the development of “fracking”

The government invest £1bn to widen broadband coverage

The Keynesian AS CurveThe classical view of LRAS suggests that the economy

will always produce the maximum that its factor resources will allow

Classical economists believe that markets will always function efficiently over the long-run, and so an economy will produce on the outer boundary of its production possibility curve, thus the LRAS curve is vertical, marking a maximum limit of production

John Maynard Keynes however, believed that an economy could be in equilibrium below full employment

Through his study of The Great Depression of the 1930’s, he concluded that the LRAS curve was upward sloping, and did have a vertical section (like the classical LRAS curve), but at times an economy could settle at a level of output below full employment

The Keynesian AS Diagram

A = Unused capacityFirms can increase output without increasing costs.B = Limited spare capacityAs the economy nears full employment, firms find it more difficult to attract scarce resources, so prices begin to rise.C = Full capacityThere is full employment and all resources are used.

Price Level

Real National Output

LRAS

P

FE

A

B

C

Draw a production possibility diagram to help explain the LRAS curve.

Shifts in the Keynesian LRAS Curve

Price Level

Real National Output

LRAS

P

FE FE1

LRAS1

LRAS2

FE2

As per the classical LRAS curve, any change in either the quantity or quality of factors of production will shift LRAS.

Which LRAS Curve Should You Use? It depends! It is crucial to understand the difference between the short-run

and long-run aggregate supply curves, this is a common area of testing on Section A of the ECON2 paper

In terms of the long-run, you should have an understanding of both models, as this will allow you to explain and evaluate more fully the impact of economic policy

The Keynesian version is arguably more “realistic” in its approach and can often be applied to a range of explanations regarding the behaviour of an economy, but it is worth noting that neither the classical nor Keynesian model are free from problems, and both have a number of assumptions lying behind their theory

The crucial point to note is that they are “models” and should be used as such, rather than perfect predictors of how an economy might behave

The Institutional Structure of the Economy

Institutions, such as the banks, play an important role in the economy

These organisations act as a support mechanism for businesses providing legal, technical or other support

They also provide access to financial support that will help businesses to invest

This gives businesses the confidence to develop their business plans, helping to increase the productive potential of the economy

The Role of the Banking System

The banking system provides the investment funds required for businesses

This allows for investment in capital goods such as machinery

Increased capital stock will lead to a shift to the right of the LRAS curve

A strong banking system is essential in creating the conditions required for investment

What happens when the banking system is not “strong”?

Multiple Choice 1

Which one of the following developments is most likely to cause the shift in the long-run aggregate supply curve from LRAS1 to LRAS2?a) Growth in export marketsb) Improvements in the banking system

that increase the funds available for investment

c) An improvement in consumer confidenced) A sustained increase in government

spending on welfare benefits

Can you explain your answer?

Price

Level

Real National Output

LRAS1

LRAS2

Multiple Choice 2

The shift in the LRAS curve is most likely to have been caused by a fall in

a) the capital stock

b) income tax rates

c) the growth of labour productivity

d) interest rates

Can you explain your answer?

Price

Level

Real National Output

LRAS2

LRAS1

Multiple Choice 3

A country’s banking system is an important part of the institutional structure of the economy because of its rolea) as a source of investment funds for businessb) in determining the economy's target rate of inflationc) in managing the country’s balance of paymentsd)as a major employer of labour in the economy

Can you explain your answer?

Multiple Choice 4

All other things being equal, which one of the following is most likely to cause a simultaneous shift to the right in both an economy’s short-run and long-run aggregate supply curves? An increase ina) the number of immigrants entering the countryb) the rate of interestc) the rate of VATd) the minimum wage rate

Can you explain your answer?

2.8 You should be able to:Define long-run aggregate supplyExplain and analyse the determinants of long-run aggregate supply Illustrate the effects of changes in long-run aggregate supply on a

diagramUnderstand why the long-run aggregate supply curve is assumed to

be verticalUnderstand and explain the Keynesian long-run aggregate supply

curveUnderstand the importance of the institutional structure of the

economyUnderstand and explain the role of the banking system in providing

business investment funds