What are the key factors that affect long run aggregate supply?

Key factors that have an effect on a country’s supply-side potential:

1. Higher Productivity of Labour and Capital i.e. a rise in output per person employed or increased efficiency of technology
2. Increased Labour Market Participation (Growing Labour Supply) - what policies can help increase employment?
3. Demand and Supply-Side gains from Innovation and Enterprise - two key factors that determine competitiveness
4. Capital Investment – including capital spending by domestic businesses, inward investment from overseas and Public Sector (Government)

A long run production function is written as follows:

Y*t = f (Lt, Kt, Mt)

• Y* is a measure of potential output
• t is the time period
• L represents the quantity and quality of labour input
• Kt represents the available capital stock
• Mt represents the availability of natural resources

LRAS is determined by the stock of a country’s resources and by the productivity of these factor inputs (labour, land and capital).

Changes in technology also affect potential real national output.

Causes of shifts in the long run aggregate supply curve

• Any change that alters the natural rate of growth of output shifts LRAS
• Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause the LRAS curve to shift out. This is shown in the diagram below
• An increase in the size of the productive capital stock of a country will also shift out the LRAS e.g. arising from the effects of infrastructure investment or an injection of investment from overseas (FDI)

Policies to increase long run aggregate supply

1. Expanding the labour supply - e.g. by improving work incentives and relaxing controls on inward labour migration. In the long term many countries must find ways of overcoming the effects of an ageing population and a rising ratio of dependents to active workers
2. Increase the productivity of labour – e.g. by investment in training of the labour force and improvements in the quality of management of human resources. Productivity can be measured in several ways including output per person employed and output per hour worked
3. Improve mobility of labour to reduce certain types of unemployment for example structural unemployment caused by occupational immobility of labour. If workers have more skills and flexibility, they will find it easier to get work. Conversely when unemployment remains high, the economy loses out on potential output and there is a waste of scarce resources
4. Expanding the capital stock – i.e. increase investment and research and development
5. Increase business efficiency by promoting greater competition within markets
6. Stimulate invention and innovation – to promote lower costs and improvements in the dynamic efficiency of markets. Innovation creates new goods and services and encourages investment

Aggregate Supply Shocks

Aggregate supply shocks might occur when there is

A sudden rise in oil or gas prices or other essential inputs such as foodstuffs used in food-processing industries. Foodstuffs are intermediate products – i.e. items used up in manufacturing goods for consumers to buy

The invention and widespread diffusion of a new production technology

A major change in the movement of migrant workers from one economy to another

Shocks and long run aggregate supply

• The effects of temporary supply-side shocks are normally to cause a shift in the SRAS curve
• There are occasions when changes in production technologies or step-changes in the productivity of factors of production that were not expected causes a shift in the long run aggregate supply curve.
• Large-scale natural disasters and persistent political conflicts including civil wars can also have a significant effect on a country’s productive potential and therefore affect the LRAS. Conflict has generational effects on a nation’s productivity, investment and potential output.

Keynesian Supply Curve