Definition
The Long-Run Aggregate Supply (LRAS) is a concept in macroeconomics that describes a period when the prices of resources, especially wages, have all fully adjusted to all changes in the economy. It represents the maximum quantity of goods and services an economy can produce when both capital and labor are fully employed. The LRAS curve is usually depicted as perfectly vertical, reflecting the fact that the quantity of total output is entirely dictated by the supply of inputs in the long run, irrespective of the levels of demand.
Key Takeaways
- Long Run Aggregate Supply (LRAS) represents the total amount of goods and services that an economy can produce when both labor and capital are fully utilized. It is also referred to as the economy’s ‘natural level of output’ or ‘full employment output’.
- Unlike Short Run Aggregate Supply, LRAS is not affected by price changes and is therefore vertical in a supply and demand graph. This means that in the long run, it’s the economy’s productive capacity that determines the level of output thus making the supply price inelastic.
- Several factors can affect the LRAS such as technological advances, changes in education and training, increases in capital stock and improvements in the institutional and regulatory frameworks of an economy. These factors can potentially increase the productive capacity and thus shift the LRAS curve to the right.
Importance
Long-Run Aggregate Supply (LRAS) is an important concept in finance because it represents the total quantity of goods and services that an economy can produce when both labor and capital are fully utilized.
Understanding LRAS is essential to observe the economy’s full potential, helping policymakers and analysts estimate the extent of economic growth and plan for future economic conditions.
It is also used by economists to evaluate the impact of economic policy and external shocks on the growth potential of an economy.
LRAS is vertical, illustrating that potential output or supply is not affected by changes in the price level in the long run, which differentiates it from the short-run aggregate supply curve.
Therefore, it plays a key role in long-term macroeconomic models.
Explanation
The Long-Run Aggregate Supply (LRAS) is an important concept in macroeconomics and is primarily used to describe a country’s potential output or capacity. In other words, it represents the maximum amount of goods and services an economy can produce when all its resources are fully utilized, assuming that labor, capital, and efficiency of factors remain constant over time. It helps economists estimate the sustainable capacity of an economy without causing inflation.
From a planning perspective, LRAS is an important tool for governments and policy makers as it gives a benchmark against which short term economic performance can be measured. The purpose of long-run aggregate supply, besides depicting the totality of an economy’s production capabilities, is to establish a relationship with its price level in the long run. This relationship is often visualized through the LRAS curve, which is typically vertical, indicating that changes in the price level do not affect the economy’s output in the long run.
Notably, it is used to analyze economic growth policies and potential issues such as structural unemployment. When actual output in an economy (represented by GDP) is below the LRAS, there may be underutilization of resources signalling room for growth, while output above LRAS often points towards overutilization which might lead to inflation. Therefore, understanding LRAS aids in designing appropriate policies aimed at sustaining economic stability and growth.
Examples of Long-Run Aggregate Supply
Economic Growth: An example of long-run aggregate supply could be a country like China, which has experienced significant economic growth over the past few decades. This growth can be attributed to an increase in their long-run aggregate supply, which was facilitated by substantial investments in infrastructure, technological advancements (like automation and digitalization), improvements in human capital through education and training, and a conducive business environment attracting foreign investments.
Recovery from Recession: The US economy after the 2008 Global Financial Crisis can be another example. After the crisis, the economy faced a severe decline and high unemployment rates. However, in the long run, the aggregate supply increased due to the implementation of various steps including rounds of quantitative easing, tax cuts, and stimulus packages. This led to an increase in consumer and business confidence, increased demand, and ultimately drove the increase in the long-run aggregate supply as companies hired more workers and improved their production capabilities.
Resource Discovery or Depletion: An example can be a country like Saudi Arabia, which has a vast reserve of oil. Discovery of the oil reserves markedly increased the country’s long-run aggregate supply, by significantly adding to its productive potential. Conversely, depletion of a critical resource would lead to a reduction in the long-run aggregate supply – for example, if a country highly dependent on a particular natural resource for its production were to deplete the resource and fail to find an alternative source or substitute technology.
Long-Run Aggregate Supply – FAQ
1. What is the Long-Run Aggregate Supply?
The Long-Run Aggregate Supply (LRAS) is an economic concept that describes the total quantity of goods and services that a nation’s firms are willing and able to produce when resources are fully employed. Unlike short-run aggregate supply, LRAS is not influenced by the price level and is based on the level of maximum output achievable without causing inflation.
2. What factors can shift the Long-Run Aggregate Supply curve?
Several factors can shift the LRAS curve. These include changes in technology, changes in capital stock, changes in the available labor, and changes in the level of education and training. A positive change in any of these factors can shift the LRAS curve to the right, indicating an increase in potential output. Conversely, a negative change can shift it to the left.
3. What is the difference between Short-Run Aggregate Supply and Long-Run Aggregate Supply?
The difference between the Short-Run Aggregate Supply (SRAS) and the Long-Run Aggregate Supply (LRAS) lies in what influences them. SRAS can be influenced by price levels and demands for immediate production, while LRAS is dependent on the productive resources available like labor, technology, and natural resources. Moreover, SRAS can exist in a state of disequilibrium, while LRAS always represents a state of equilibrium.
4. What is the relationship between Long-Run Aggregate Supply and Gross Domestic Product?
The Long-Run Aggregate Supply is related to the potential output or potential Gross Domestic Product (GDP) of the economy. It represents the maximum sustainable amount of output (GDP) that an economy can produce. When the economy is at LRAS, actual GDP equals potential GDP and the output gap is zero.
Related Entrepreneurship Terms
- Real Output: This term refers to the total amount of goods and services produced within an economy at a given overall price level in a given time period.
- Economic Growth: This involves an increase in the amount of goods and services produced per head of the population over a period of time.
- Productive Capacity: This is the maximum possible output of an economy. It is also referred to as the production capability or the maximum possible production capacity of an economy.
- Potential GDP: It represents the maximum amount of output an economy can sustain over a period of time without causing inflation.
- Capital Stock: Refers to the total physical capital—factories, machinery, tools, computers, buildings and infrastructure—that businesses use in production.
Sources for More Information
- Cengage: An educational content provider that covers a wide range of academic disciplines including finance and economics.
- Investopedia: A comprehensive online financial education site with an extensive dictionary of finance and investment terms.
- Corporate Finance Institute: A professional skills training provider with numerous resources on financial topics.
- Khan Academy: A substantial repository of free online courses, lessons, and practice activities in various disciplines, including economics and finance.
