A Level Economics 75: The Long Run Aggregate Supply

 Long Run Aggregate Supply (LRAS):

The Long Run Aggregate Supply (LRAS) represents the total output of goods and services that all firms in an economy are willing and able to produce in the long run when all input prices, including wages, have fully adjusted to changes in the overall price level. It is important to note that the LRAS curve is vertical at the full employment level of output.

Differences between Keynesian and Neo-Classical Views on LRAS:

1. Keynesian View: Keynesian economists argue that the LRAS curve is not necessarily vertical at the full employment level of output. They believe that the economy can have persistent unemployment or output gaps in the long run due to factors like inflexible factor markets, which prevent wages from adjusting quickly to changes in demand and prices.

2. Neo-Classical View: Neo-Classical economists, on the other hand, contend that the LRAS curve is vertical at the full employment level of output. They believe that the economy will tend to reach full employment in the long run as all input prices, including wages, are flexible and can fully adjust to changes in demand and supply.

Neo-Classical View of Long Run Equilibrium:

The Neo-Classical view describes the process through which an economy adjusts to its long-run equilibrium as follows:

1. Flexible Prices and Wages: In the long run, all prices and wages are assumed to be flexible and can adjust freely to changes in demand and supply. This implies that any deviations from the full employment level of output will be temporary, as prices and wages will adjust to restore equilibrium.

2. Self-Correcting Mechanism: If there is an increase in aggregate demand (AD) that pushes the economy beyond the full employment level of output, firms will experience higher demand for their products. They will respond by increasing prices and production, but with fully flexible wages, labor costs will rise in line with prices. As a result, production costs increase, and firms will eventually cut back on hiring and production, moving the economy back towards full employment.

3. Equilibrium at Potential Output: In the Neo-Classical view, the economy will tend to reach its potential output or full employment level in the long run due to the flexibility of prices and wages. This results in a vertical LRAS curve at the full employment level of output.

Keynesian Disagreement with the Neo-Classical View:

Keynesian economists disagree with the Neo-Classical view of long-run adjustment due to factors such as:

1. Inflexible Factor Markets: Keynesians argue that in the short run, factor markets, especially the labor market, may not be flexible enough to adjust quickly to changes in demand and prices. Wages may be "sticky," meaning they do not adjust downward in response to decreased demand, leading to persistent unemployment and deviations from full employment in the long run.

2. Aggregate Demand Management: Keynesian economists advocate for active government intervention through fiscal and monetary policies to manage aggregate demand and stabilize the economy. They believe that relying solely on the self-correcting mechanism of flexible prices and wages may not be sufficient to achieve full employment in the short run.

Assumptions of Flexible Product and Factor Markets:

The Neo-Classical analysis of LRAS is based on the following assumptions:

1. Flexible Prices: All prices, including those of goods and services, can freely adjust to changes in demand and supply conditions.

2. Flexible Wages: Wages can adjust promptly to changes in labor market conditions, ensuring that labor costs align with productivity and prices.

3. Rapid Market Clearing: Markets clear quickly, meaning that any imbalances between demand and supply are corrected swiftly through price and wage adjustments.

Understanding the differences between Keynesian and Neo-Classical views on the LRAS curve and the assumptions underlying each analysis is essential for comprehending the different approaches to macroeconomic policy and the potential implications for economic stability and full employment.

A Level Economics 73: Introduction to Aggregate Supply

 The Aggregate Supply (AS) Function:

The Aggregate Supply (AS) function represents the total output of goods and services that all firms in an economy are willing and able to produce at different price levels. It is crucial to distinguish between the short run and the long run in the context of the AS function. In the short run, some input prices may be fixed or sticky, while in the long run, all input prices are flexible and can adjust fully.

Shape of the Keynesian Long Run Aggregate Supply (LRAS) Curve:

The Keynesian Long Run Aggregate Supply (LRAS) curve is a horizontal line that indicates the level of aggregate supply in the long run when the economy is not operating at full employment. Unlike the classical or neoclassical LRAS curve, which is vertical at the full employment level of output, the Keynesian LRAS curve is horizontal or flat. This suggests that, in the long run, the economy can have persistent unemployment or output gaps.

Factors Resulting in a Shift in LRAS:

1. Changes in Quantity, Quality, and Efficiency of Factors of Production: An increase in the quantity of factors of production, such as labor and capital, can lead to an outward shift of the LRAS curve. Similarly, improvements in the quality and efficiency of these factors can also result in a higher LRAS. For example, if the workforce becomes more skilled and educated or if technological advancements enhance productivity, the LRAS curve can shift to the right.

2. Changes in the State of Technology: Technological advancements can significantly impact LRAS. Improvements in technology lead to increased productivity and efficiency, allowing firms to produce more output at the same cost, leading to an outward shift of the LRAS curve.

3. Changes in Factor Market Flexibility: If factor markets become more flexible, for example, through labor market reforms or reduced barriers to entry for new businesses, this can enhance resource allocation efficiency and lead to a higher LRAS.

LRAS Vertical at Full Employment:

It is essential for learners to understand that the Keynesian LRAS curve is different from the classical or neoclassical LRAS curve. The Keynesian LRAS curve is horizontal, indicating that the economy can have deviations from full employment in the long run. This means that in the long run, the economy's productive capacity is not fully utilized, and there is the possibility of cyclical unemployment.

Using Policy Instruments to Shift LRAS:

Changes in policy instruments can be implemented to bring about shifts in the LRAS curve and improve the economy's productive capacity:

1. Investment in Education and Training: By investing in education and skill development, the quality and efficiency of the labor force can improve, leading to an outward shift of LRAS.

2. Infrastructure Development: Building better infrastructure can enhance the productivity of businesses, reducing costs and increasing potential output.

3. Research and Development (R&D) Support: Encouraging R&D activities can foster technological advancements, contributing to a higher LRAS.

4. Labor Market Reforms: Implementing policies that increase labor market flexibility, such as reducing minimum wage rigidity or easing labor market regulations, can boost LRAS.

5. Tax Incentives for Investment: Providing tax incentives to businesses for capital investment can encourage technological progress and lead to an increase in LRAS.

By implementing appropriate policy measures, governments can positively impact the LRAS curve and promote economic growth and full employment in the long run. It is essential for learners to understand these policy instruments and their potential effects on the economy's productive capacity.