In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology and the availability and quality of factor inputs
Key factors that have an effect on a country’s supply-side potential:
Higher Productivity of Labour and Capital i.e. a rise in output per person employed or increased efficiency of technology
Increased Labour Market Participation (Growing Labour Supply) - what policies can help increase employment?
Demand and Supply-Side gains from Innovation and Enterprise - two key factors that determine competitiveness
Capital Investment – including capital spending by domestic businesses, inward investment from overseas and Public Sector (Government)
Growth and size of economy
“Seemingly small differences in growth rates can have a large impact over a period of many years. For example, if an economy grew by 2 per cent every year, it would double in size within 35 years; if it grew at 2½ per cent a year, it would double in size after 28 years - seven years earlier”
Source: UK Treasury
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
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
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
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
Expanding the capital stock – i.e. increase investment and research and development
Increase business efficiency by promoting greater competition within markets
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.
Geoff Riley FRSA has been teaching Economics for nearly thirty years. He has twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.
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