Long-Run Aggregate Supply

LRAS is an approach that explains how much an economy can produce by using all factors of production to their optimum capacity. In the long run, when all the factors become variable and there is full economic employment, the output obtained does not depend on the price level.

In the long run, the output depends on resources like technology, capital, labor, and natural resource. In the short run, they cannot adjust to changes in price, but in the long run, they do so. The price does not affect supply in the long run, due to which the supply curve appears to be a vertical line.

• LRAS refers to the output level a country can produce through the optimum use of resources.
• In the long run, all factors of production become variable, and there is full employment in the economy.
• The resources used are capital, labor, technology, and natural resource, which do not adjust with price in the short run.
• But in the long term, prices do not affect the supply because wages and other factors adjust to changes in price, leading to a vertical long-run aggregate supply graph.

The economy's long-run aggregate supply curve shows the level of output that an economy can produce in the long run. All production factors, including labor, capital, technology, and natural resource, become variable in this time frame. They adjust to changes in price. Thus, the long-run aggregate supply graph is vertical because the price cannot influence the output. Due to this, during the long run, an economy's economic growth continues despite inflation in the short run.

In other words, the curve shows how much supply an economy would have achieved if all factors were fully flexible. It makes the relationship between the GDP of a country and price easy to understand. However, this analysis is possible only if a sufficient period is available. The long run does not refer to any fixed time frame. Instead, it relates to that time gap when all factors can adjust fully, and it is impossible to change the output in any way since it shows the production level at full employment.

Some factors influence the LRAS curve.

• Labour supply – Labour supply depends on population growth, level of immigration, and the number of people participating in the labor force. An increase in labor will leads to a rise in output. Thus, there are long-run aggregate supply curve shifts towards the right side.
• Natural resource – Natural resource is an essential input during production. The natural resource includes various things like land, water, oil, etc. when there is a higher natural resource supply, the LRAS curve shifts to the right side.
• Human resource supply – A rise in human capital increases the output of the productivity of an economy. The output will increase if the workers are skilled, well-trained, and have the proper education needed for the work. Thus, an improvement in human resources will shift the economy's long-run aggregate supply curve to the right.
• Technological development – Technological development leads to increased production because there is a better use of plant and machinery and the upgradation of labor, which increases productivity. The rise in productivity reduces the cost of labor and helps in earning more profit.
• Physical capital supply – Physical capital refers to investments in plant and machinery, software and hardware, and also property. An increase in the physical capital leads to a rise in production level because workers and employees use better equipment that is technologically advanced. Thus, there are shifts in long-run aggregate supply towards the right side.

The formula for the LRAS curve is mentioned below:

Y = Y*   

In the above formula:

Y = Total production of goods and services in the economy.

Y*= Natural level of production.

The above formula is derived from the short-run aggregate supply, which is as follows:

Y = Y* + a (P – Pe)

Where:

a = coefficient > 0

P = Price level

Pe = The price level anticipated by customers.

In the short-run aggregate supply formula, the supply is affected by the price level because if the price rises, profit increases due to increased output. But in the case of LRAS, price does not play any role. Output is unaffected by changes in price. Thus, P – Pe = 0. In the long run, what remains is Y = Y*, which is the formula for the LRAS curve.

Let us understand the concept better through some examples:

Example #1

Star Industries Ltd, a leading cosmetics manufacturing company based in California, USA, has been operating in the market for the last 20 years. It has spread its business to various other parts of the world. Its main product is cold cream, which sells the most during winter.

The company has noticed that the cold cream’s demand increases during the winter seasons. Thus, all player in the cold cream market raises their prices during those seasons. Star Industries Ltd takes advantage of this rise in price to ramp up its output to increase the profit margin. Here we see that in the short run, due to an increase in price, output and profit increase, whereas wages, capital, and technology remain fixed since they cannot adjust to a change in price so soon.

However, in the long run, all factors of production become variable. An increase in output raises the worker’s wage, and the company invests more in technology and capital. The profit margin is absorbed in the process. Therefore, the price change does not affect the supply in the long run. In the case of Star Industries Ltd, the classical long-run aggregate supply curve perfectly works out. The variability in the various factors of production nullifies the effect of the price rise, and the output remains the same.

Example #2

The US government has been forced to increase interest rates due to excessive inflation or a rise in the prices of goods. But excessive use of this tool will have long-term adverse effects on the US economy.

The rise in interest rates has resulted in a demand reduction since people do not want to borrow money and pay high interest. Thus, there is a fall in demand and investment since even corporations are taking fewer loans to finance their business.

Thus, it is necessary to increase the supply side to expand growth opportunities. Supply can be increased in various ways, like providing better child-care facilities to increase labor participation and arranging for the fastest COVID-19 vaccination process to get the maximum number of people vaccinated. The country can also encourage immigration by reducing the minimum immigration age for workers, increasing the supply of renewable resources, and developing technology.  

To understand the LRAS curve, let us assume there is output on the X-axis and price on the Y-axis, as shown in the graph below. In a more extended time, changes in the price level do not affect the output even though the price rises from P1 to P2.

Thus, during a longer time frame, the output will return to Y1 because, in the short run, when the price rises from P1 to P2, manufacturers take advantage of the higher price and ramp up their production from Y1 to Y2. Factors like wages, technology, capital, etc., can only adjust later with a price change. But in the long run, wages and other factors that were inflexible in the short run adjust slowly.

The classical long-run aggregate supply curve appears vertical since the change in price does not affect it. It also proves that since prices adjust in the long run, production takes place at optimum use of resources, which signifies full employment.

The LRAS shows the level of supply or output when all factors of production are variable. In contrast, short-run aggregate supply shows the changes in output level in the short run due to price changes, and the capital remains fixed. Let us compare both of them.

This article has been a guide to Long-Run Aggregate Supply & its definition. We explain its formula, examples, curve, & difference with short-run aggregate supply. You can learn more about it from the following articles –

• Aggregate Production Function
• Aggregate Supply
• Recessionary Gap