Source: Principles of Macroeconomics, Case/Fair, 8e
Difficulty: Intermediate Prerequisites: Part 1 of these notes (the aggregate demand curve), plus basic understanding of input costs and firm pricing.
Tags: aggregate supply, AS curve, short-run aggregate supply, long-run aggregate supply, LRAS, potential output, equilibrium price level, capacity, input prices, wage stickiness, vertical AS curve, macroeconomics
The aggregate supply curve is the other half of the AD/AS model. While AD tells you how much output buyers want at each price level, AS tells you how much output firms are willing to produce. The crucial insight here is that the AS curve behaves very differently in the short run vs. the long run, and where the economy sits on the AS curve determines whether policy changes mostly affect output or mostly affect prices. This section also covers how AD and AS together pin down the equilibrium price level and output.
The aggregate supply curve shows the total output firms produce at each price level. In the short run, it slopes upward because input costs (especially wages) are sticky. At full capacity it becomes vertical, meaning higher prices cannot squeeze out more output. The long-run AS curve is vertical at potential output, where all costs have fully adjusted to prices.
Aggregate supply (AS) curve
The curve showing the relationship between the overall price level and the total quantity of output supplied by all firms in the economy. It is not the sum of individual firm supply curves and does not follow the same logic as a single firm's supply curve.
Short-run aggregate supply (SRAS)
The AS curve when input prices (wages, raw materials) have not yet fully adjusted to changes in the price level. It is upward-sloping because firms can increase output when product prices rise faster than their costs.
Long-run aggregate supply (LRAS)
The vertical AS curve at the level of potential output. In the long run, wages and other input costs fully adjust to price-level changes, so the economy produces at potential output regardless of the price level.
Potential output (potential GDP)
The level of aggregate output that can be sustained in the long run without generating inflation. This is not the absolute maximum the economy can produce; it is the level consistent with full employment of resources. In simple terms, it is the economy's "cruising speed."
Full capacity
The point at which all resources are fully utilised. On the AS curve, this is where the curve becomes vertical. No amount of price increase can generate more output beyond this point.
Sticky wages / sticky input prices
In the short run, wages and other costs do not adjust instantly to changes in the price level, often because of contracts, minimum-wage laws, or slow negotiation. This stickiness is why the short-run AS curve slopes upward rather than being vertical.
Cost-of-living adjustments (COLAs)
Contract clauses that automatically raise wages when the price level increases. The more workers covered by COLAs, the steeper the AS curve becomes, because costs keep pace with prices more closely.
The AS curve has three distinct regions:
Flat region (excess capacity): When the economy is well below capacity, firms can increase output without raising prices much. Input prices are essentially fixed because there is plenty of spare labour and idle equipment. An increase in AD here produces a large change in output and a small change in the price level.
Upward-sloping region (approaching capacity): As output rises, bottlenecks appear. Some inputs become scarce, costs start rising, and firms pass these on as higher prices. The relationship between the price level and output is positive here.
Vertical region (at or beyond capacity): The economy cannot produce more. All resources are fully employed. Any increase in AD causes only higher prices with no change in output.
The slope depends on how fast input prices (especially wages) respond to changes in the price level:
If input prices adjust slowly (sticky wages), the AS curve is relatively flat. Firms benefit from rising product prices while their costs lag behind, so they expand output.
If input prices adjust quickly (e.g. many workers have COLAs), the AS curve is steeper.
If input prices adjust at exactly the same rate as output prices, the AS curve is vertical. There is no profit incentive to expand output when costs and revenues move in lockstep.
In the short run, wages and interest rates are relatively fixed. When the price level rises, firms receive more for their output while their costs have not yet caught up. This gap makes production more profitable, so firms increase output.
A change in the price level causes a movement along the AS curve. It does not shift the curve.
The AS curve shifts when there is a change in input costs, technology, the labour force, or capital stock, independent of the current price level.
Rightward shifts (AS increases):
Decrease in input prices (cheaper oil, raw materials)
Technological progress
Increase in the labour force (e.g. immigration)
New capital investment
Deregulation
Leftward shifts (AS decreases):
Increase in input prices (oil embargo, coal strike)
Natural disasters destroying infrastructure or capital
Lack of capital investment
Increased regulation or higher business taxes
In the long run, all input prices fully adjust to changes in the output price level. Wages catch up, raw material contracts are renegotiated, and so on. Because costs and prices move together, there is no incentive for firms to produce more or less than potential output.
The LRAS is vertical at the level of potential output.
The LRAS is vertical if (and because) wages and other costs fully adjust to changes in prices in the long run.
Potential output is not the absolute maximum. The economy can temporarily exceed potential output, but doing so generates inflation as input costs rise to catch up.
Potential output is the output level sustainable without inflation. It corresponds to the LRAS curve.
It is not the absolute most the economy can produce. In the short run, output can exceed potential, but this is unsustainable because it creates inflationary pressure.
When actual output exceeds potential GDP, the price level rises.
When long-run aggregate supply increases (due to technological progress, population growth, capital accumulation), potential output increases.
Equilibrium occurs where the AD curve intersects the AS curve. At this point, the quantity of output demanded equals the quantity supplied, and there is no pressure for the price level to change.
The intersection of AS and AD does not necessarily represent full employment. The economy can be in equilibrium below full employment (a recessionary gap) or above potential output (an inflationary gap, which creates price pressure).
On the flat part of AS: Expansionary policy increases output with little effect on the price level. Policy is effective at boosting output.
On the steep part of AS: Expansionary policy mostly increases the price level with little increase in output.
At capacity (vertical AS): Expansionary policy increases only the price level. Output cannot rise. Government spending completely crowds out investment.
Long-run equilibrium condition:
Potential output is where LRAS is vertical. If actual output > potential output, prices rise until the economy returns to potential. If actual output < potential output, input prices fall, AS shifts right, and the economy returns to potential.
Policy multiplier in the long run:
If the LRAS is vertical, the multiplier effect of a change in net taxes (or government spending) on aggregate output is zero in the long run. Policy changes only affect the price level.
Hurricane Katrina (2005) destroyed a large portion of infrastructure in the Gulf Coast, shifting the short-run AS curve to the left. This meant lower output and higher prices, all else equal. Oil price shocks in the 1970s had a similar effect globally: the sharp rise in energy costs shifted AS left, producing both recession and inflation simultaneously.
On the other side, the technology boom of the 1990s, with heavy capital investment by firms, shifted the AS curve to the right, expanding potential output and supporting growth with relatively low inflation.
Students often think the AS curve is the sum of individual firm supply curves. It is not, and it does not follow the same logic.
A rise in the price level does not shift the AS curve. It causes a movement along it. Only changes in underlying costs, technology, labour force, or capital shift the AS curve.
Students confuse "potential output" with "maximum possible output." Potential output is the sustainable level without inflation. The economy can temporarily exceed it, but at the cost of rising prices.
A common error is thinking that the AS/AD intersection always represents full employment. It does not. The economy can be in equilibrium with a recessionary gap or an inflationary gap.
⚠️ Know the three regions of the AS curve (flat, upward-sloping, vertical) and what happens to prices vs. output in each when AD shifts.
⚠️ Distinguish between what shifts the AS curve (input costs, technology, labour force, capital) and what causes movement along it (price-level changes).
⚠️ The LRAS is vertical because wages and costs fully adjust to prices in the long run. This is a frequently tested concept.
⚠️ If the economy is at capacity, an increase in AD increases only the price level. Government spending completely crowds out investment. This is a key exam point.
⚠️ Potential output equals long-run aggregate supply, not short-run aggregate supply or aggregate demand.
⚠️ If input prices change at the same rate as output prices, the AS curve is vertical.
True or false: If the price level rises, the aggregate supply curve shifts to the right. ______
When the AS curve is vertical, the economy is producing at _______.
True or false: The aggregate supply curve is the sum of all individual supply curves. ______
If the economy is on the flat part of the AS curve, an increase in AD causes a ______ (big/small) change in output and a ______ (big/small) change in the price level.
True or false: Potential output is the most that an economy can produce at a given point in time. ______
Answers: 1. False (movement along, not a shift) 2. full capacity / potential output 3. False 4. big, small 5. False (potential output is the sustainable level without inflation; the economy can temporarily exceed it)
Q: What determines the slope of the aggregate supply curve?
A: How fast the prices of factors of production respond to changes in the overall price level. The slower input prices adjust, the flatter the curve.
Q: If the economy is operating close to capacity, what does an increase in aggregate demand do?
A: It causes a big increase in the price level and a small increase in output. Near capacity, there is very little room to expand production, so the extra demand mostly pushes prices up.
Q: What would cause the short-run aggregate supply curve to shift to the left?
A: An increase in the price of key inputs (e.g. an oil price spike, a coal miners' strike), a natural disaster that destroys capital or infrastructure, or an increase in business taxes.
Q: What would cause the short-run aggregate supply curve to shift to the right?
A: A decrease in input prices, technological progress, an increase in the labour force (e.g. immigration), or new capital investment by firms.
Q: The long-run aggregate supply curve is vertical because ______.
A: Wages and other costs fully adjust to changes in prices in the long run. When input costs move in lockstep with output prices, there is no incentive for firms to produce more or less than potential output, regardless of the price level.
Q: If actual equilibrium output exceeds potential GDP, what happens?
A: The price level rises. Operating above potential is unsustainable because input costs (wages, materials) begin rising, shifting the short-run AS curve left and pushing the economy back toward potential output.
Q: What combination of policies would increase output?
A: Policies that increase both aggregate supply and aggregate demand, such as encouraging education (AS shift right), lowering payroll taxes (AS shift right), increasing government spending (AD shift right), or having the Fed buy bonds in the open market (AD shift right).
The AS curve builds on the theory of the firm and production costs from microeconomics. The distinction between short-run and long-run AS connects to the classical vs. Keynesian debate covered later in the course. The equilibrium section here sets up Chapter 13's later discussion of inflation and policy trade-offs (covered in Part 3 of these notes).
Related Terms / Search Tags: aggregate supply curve, AS curve, SRAS, LRAS, short-run aggregate supply, long-run aggregate supply, potential output, potential GDP, full capacity, sticky wages, input prices, wage adjustment, AS curve slope, AS shifts, oil price shock, equilibrium price level, AD-AS model, recessionary gap, inflationary gap, crowding out, policy effectiveness, ECO 101, Case Fair Chapter 13