Aggregate Supply

Aggregate Supply Definition

Aggregate supply also known as domestic final supply refers to the overall supply of products and services that organizations are able to sell at a particular price in an economy and these are consumer products that are purchased by the customers for personal consumption purposes only.

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#1 – Consumer goods

These are the products that are bought by the end-user for personal consumption. It is the single major constituent in Aggregate supply. These are also labeled as final goods or finished products as they often are the final product in the manufacturing cycle and will eventually be available at retailer shops for the end consumer and households.  Example Bread, butter, soaps, TV, Fridge, etc.

#2 – Capital goods

Capital goods are tangible assetsTangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and more that are used by manufacturers and industrialists to eventually produce consumer goods. If consumer goods are the final products of the manufacturing cycle, capital goods are tools that help transform raw materials into these final products or services. An example of capital goods is airplane manufacturers which are used by airlines to provide travel services to consumers.

#3 – Public and merit goods

These are mainly the goods or services provided by firms for public welfare like education, public transport, healthcare. They are also a significant part of aggregate supply as a large part of economy flourishes on enabling the infrastructure so that these products can reach the end-user comfortably like IT services, pharma, transport

#4- Traded Goods

These are the goods and services that are produced for export and help in making the economy compete globally.

Aggregate supply in an economy is calculated at a corresponding price level for a particular period of time. It is represented graphically by aggregate supply curve which defines the relationship between the goods that firms produce and the price levels at which they are provided.

Short Run Aggregate Supply vs Long-Run Aggregate Supply

Aggregate supply can be classified into short-run supply and long-run supply. The short-run aggregate supply is driven by price. When the demand for goods and services in an economy increases, there are relatively more buyers which affect the demand-supply equilibrium. This increases the prices of the commodities as customers are willing to shell out more. Firms respond to this by increasing supply to gain more profits. However, they can only increase supply till they reach the maximum capacity. In the short term, businesses can’t reach capacity overnight. For example, a company cannot buy a piece of land and start new plant operations to increase capacity. Such decisions take time and have an upfront cost involved.

However, in the long run, if prices show an upward trend then businesses can strategize and increase capacity with time. This increased capacity will automatically boost supply. In the long run, more capital can be infused into the business to drive improvements in productivity, efficiency, technical know-how of workers, technological advancements, etc. Simply put, in short, run prices can change but productivity factors like wages, hikes, machinery, equipment and technology set up are held constant, but in long term, both prices and productivity factors can change.

Graphically long-run aggregate supply (LRAS) curve is assumed to be vertical as price level changes do not affect much and supply is driven more by the technological advancements and increased efficiency in production. On the other hand, short-run aggregate supply (SRAS) is assumed to be an upward sloping as it reacts to a change in price because of an abrupt change in demand.

What Causes Shifts in Aggregate Supply?

Aggregate supply is affected by production costs and operating costs of the business. Following are some of these factors:

#1 – Change in Raw Material Costs

The raw material is the most important input cost in the manufacturing cycle. Any change to these will directly impact the production costs. For example, if the price of the iron core increases the steel firms will be affected. Either the increased prices have to be passed to the customers or supply has to be reduced to maintain the same cost of production.

#2 – Change in Labour Costs

Any increase or decrease in labor wages or labor availability will impact the production costs. For example, consider the example of auto major Maruti which had to shut down its plant for 2 months because of a labor strike. This not only decreased the supply of auto units but also increased per unit labor cost for the firm.

#3 – Increment in other Production Costs

There can be other industry-specific production costs that might vary like the rental cost of the plant, price of cement for builders or transportation costs because of the increase in oil prices. These factors though indirectly, do impact the production costs.

#4- Exchange Rates

Change in currency exchange rates may affect production costs by affecting the firms that import raw materials. In either case, the supply would be affected as the increased price will lead to reduced demand. This is the biggest worry for India based airlines as a sudden drop in rupee increase the effective crude oil prices impacting their production costs.

#5 – Taxation and Subsidies

An increase in taxation does not affect the production costs directly but increases the final price for the end consumers impacting demand and eventually supply and vice versa.

#6 – Cheaper Imports

Cheaper imports disturb the demand-supply equilibrium as goods become cheaper impacting the demand for goods for homegrown industries. For example, there was a sudden drop in smartphone prices in India when Chinese based XIOMI and One plus start dumping cheap products when the Indian smartphone market was growing at a healthy rate. These cheaper imports impacted the already existing player like Nokia and local firms like Micromax and LG.

Aggregate supply is also known as total output as effectively it determines what is produced and consumed in an economy. It is imperative for the government to make sure that aggregate supply is an upward sloping curve for economic growth to maintain else it may lead to higher inflation, lower employment, and migration of local working force.

This has been a guide to Aggregate Supply. Here we discuss its definition Aggregate Supply the constitutes Aggregate supply and Causes of Aggregate Supply Shifts. You can learn more about from the following articles –

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