Aggregate Supply

Updated on April 19, 2024
Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Aggregate Supply?

Aggregate supply refers to the total supply of products and services that businesses can sell in a national economy—at a particular price, pertaining to a particular period. It refers to consumer products that the customers purchase for personal consumption.

Aggregate Supply Meaning

The rise or fall in the aggregate demand alters aggregate supply. An increase in demand causes an increase in supply. Similarly, a fall in demand results in reduced supply. It is further classified into short-run supply and long-run supply. In the short run, supply is driven by price. In the long run, firms ramp up production.

Key Takeaways

  • Aggregate supply is the total quantity of the goods or services produced in an economy—during a given period at a particular price level.
  • Change in supply is brought out by the price of factors of production, technological advancement, labor productivity, exchange rate fluctuation, taxes, subsidies, and inflation rate changes.
  • Capital goods are used by manufacturers and industrialists to produce consumer goods. Capital goods transform raw materials into finished products.

Aggregate Supply Explained

Aggregate supply is also known as the final domestic supply. A country’s final domestic supply is calculated at the corresponding price level at a particular time. It is represented graphically by the aggregate supply curve—the relationship between goods produced and price levels.

The final domestic supply comprises capital goodsCapital GoodsCapital goods are man-made assets used in the manufacturing process of a product. They are used to produce the final goods that people consume daily. They are one of the four factors of production- the other three being natural resources, labor, and entrepreneurship.read more, consumer goodsConsumer GoodsConsumer goods are the products purchased by the buyers for consumption and not for resale. Also referred to as final products, examples of consumer goods include an Apple cellphone or a box of Oreo cookies. Consumer goods companies and the industry offer a vast range of products that heavily contribute to the global economy.read more, traded goods, and public goods. Capital goods are tangible assetsTangible AssetsTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation.read more—manufacturers and industrialists use capital goods to transform raw materials into finished products. Commercial aircraft is an example of capital goods—airlines provide travel services to consumers. Consumer goods are also referred to as finished goods—final products in the manufacturing cycle. Bread, butter, soaps, TV, fridge, etc., are examples of consumer goods.

Commodities produced for export help a nation compete globally. Public welfare services like education, public transport, and healthcare also constitute a significant part of the final domestic supply. These services require infrastructure, which in turn creates employment and generates income for the masses.

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Formula

The formula for determining the aggregate supply is as follows:

Aggregate Supply Formula

Here, AS is the Aggregate Supply.

  • C is the Consumption Expenditure, and
  • S refers to Savings.

Components

Aggregate Supply Components

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Following are the two prominent components of the final domestic supply:

  1. Consumption Expenditure: The amount spent by the consumers on purchasing goods and services in a particular period constitutes the consumption expenditure.
  2. Savings: It constitutes the consumer savings in a given period.

Determinants

Shifts in final domestic supply are caused by internal and external factors of productionFactors Of ProductionFactors of production define resources used to produce or create finished goods and services, the sale and purchase of which keeps the market economy afloat.read more. Following are the various determinants of final domestic supply or shifters of aggregate supply:

  1. Change in Raw Material Costs: Any increase or decrease in raw material costs will directly impact production costs. A rise in raw material cost may lead to a decline in supply or an increase in commodity price.
  2. Variation in Labour Costs: Any rise or fall in labor wages or labor availability will fluctuate production costs. For example, if an auto manufacturer shuts its manufacturing plant for two months, the supply will decrease—brought out by a labor strike.
  3. Change in Labour Quality and Quantity: The increase or decrease in labor also impacts the supply of goods. Similarly, a change in the quality of labor causes changes in production capacity.
  4. Fluctuation in Other Production Costs: Other industry-specific production costs also affect supply—the rental cost of manufacturing plant, price of cement for builders, or transportation cost changes caused by increasing oil prices.
  5. Exchange Rate Changes: The rise and fall of currency exchange rates may affect production costs—raw material imports. Supply can also be affected—increased price will lead to reduced demand.
  6. Taxation and Subsidies: An increase in taxes does not impact the production costs directly but increases the final price for the consumers. Thus, change in taxes impacts both demand and supply.
  7. Cheaper Imports: When imported goods become more affordable, domestic product demand decreases. Under pressure, domestic companies reduce their supply in the market. Thus, this factor is one of the significant shifters of aggregate supply.
  8. Inflation Rate Fluctuation: Final domestic supply determines what is produced and what is consumed in a national economy. To achieve sustainable growth, governments try to ensure a final domestic supply that resembles an upward sloping curve.
  9. Technological Innovation: If a company upgrades technology, production can be ramped up—supply can be increased significantly.

Thus the above are the various determinanats of the In case of the aggregate supply in the short run and long run.

Aggregate Supply Curve

An aggregate supply curve (ASC) is the graphical representation of the number of goods or services produced in relation to price changes.

Aggregate Supply Curve

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Short-run and long-run are the two final domestic supply types. They are explained below.

#1 – Aggregate Supply in Short Run

The short-run final domestic supply is driven by price. An increase in demand witnesses relatively more buyers—the demand-supply equilibrium is altered. In the In case of the aggregate supply in the short run, businesses can’t reach the required capacity overnight. For example, a company cannot always buy land and start a new manufacturing plant to increase capacity. Such decisions take time and massive expenditures that need to be paid upfront.

Without additional capital, the only way to increase output is to increase efficiency. The existing factors of production must be optimized. If achieved, higher demand would mean a price hike—eventually, higher profitability.

 Thus, the short-run final domestic supply curve shows an upward movement—it reacts to changes in price brought out by the abrupt shift in demand.

#2 – Aggregate Supply in Long Run

If the commodity prices show an upward trend over a longer period, businesses try to increase capacity. In the long run, firms can invest more capital in improving productivity, efficiency, technical know-how of workers, and technology. In the long run, prices and productivity change significantly.

The long-run final domestic supply curve is vertical. Price changes do not alter supply significantly. Changes in supply are mainly brought out by technological advancements and production efficiency.

Example

Let us understand the concept of aggregate supply function with the help of a suitable example.

Let us assume PQR Steel Industry manufactures grinder machines. The output in the financial year 2020-21 was 60,000 units, and the overall annual cost of production was $9000,000. However, in October 2021, the labor force went on a one-month strike—the manufacturing unit was temporarily shut down. Determine the shortage in supply.

Solution:

If 60000 units were produced in 12 months, the number of grinder machines manufactured in one month is 60000/12 = 5000 grinder machines.

Thus, there is a shortage of 5000 grinder machines—resulting in non-fulfillment of aggregate demand—the state of equilibrium is altered. Ultimately, the shortage in supply and the excessive demand will result in the increased price of grinder machines.

Aggregate Supply Vs Aggregate Demand

The above are two financial concepts of aggregate supply and demand that are essential in macroeconomics and gives an insight into the economic condition of the country. Let us point out the difference between them.

  • The former shows the level of goods and services supplied in an economy from the producers while the latter shows the quantity of goods and services that the buyers of the economy are ready to purchase at a given price level.
  • The former focus on the manufacturing or production side of the economy and shows the quantity of output firms plan to produce. But the latter shows the consumption side of the economy where the consumers are willing to purchase goods.
  • Both aggregate supply and demand relate to the price levels of goods and services. In the case of the former, during the short run, the curve slopes upwards, which shows a positive relationship between the output level and price level. However, the demand curve shows a negative association between quantity and price.
  • The aggregate supply function is influenced by the cost factor, supply of resources, technological development, government policy, etc whereas the latter is determined by consumer choice, government expenditure, investments made in the economy, etc.
  • The aggregate supply impacts the country’s production or output level and also has an influence on the employment and interest rates. But the aggregate demand influences the GDP growth along with other things like employment, interest rates.

A clear understanding of both the above concepts helps economists, organizations as well as individuals assess or evaluate the country’s performance and make policy decision or investment decisions that will lead to growth, expansion and stability of the country.

Frequently Asked Questions (FAQS)

What is the aggregate supply curve?

The final domestic supply curve represents the relation between the volume of goods and price—pertaining to the economy of a nation.

How does unemployment affect aggregate supply and demand?

When unemployment levels are high, consumers’ disposable income falls—aggregate demand also falls. Also, in order to match the decrease in demand, the aggregate supply has to be reduced.

What are the determinants of aggregate supply?

Final domestic supply depends on technology changes, prices of factors of production, the productivity of labor, taxes, subsidies, inflation rate, exchange rate, and cheaper import of goods or services.

This has been a guide to what is Aggregate Supply. We explain its curve with formula, component, determinant, examples & differences with aggregate demand. You can learn more about it from the articles below –

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Comments

  1. Ayero Judith Oywak says

    Wow!
    It’s an interesting economics in production
    I’ll ever prefer to attain more knowledge from here, thanks.

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