Aggregate Supply Explained: What It Is and How It Works

What Is Aggregate Supply?

The term aggregate supply refers to the supply of products that companies produce and plan to sell at a certain price in a given period. Put simply, it refers to the finished goods that consumers purchase during a specified time. Aggregate supply is represented by the aggregate supply curve. There is typically a positive relationship between aggregate supply and the price level.

Understanding Aggregate Supply

Aggregate supply refers to the total supply of final goods and services produced by companies that they plan to sell at a certain price within a specific time. It can be contrasted by simple supply which is the product or service available from a single or individual producer

Put simply, aggregate supply is the economy's gross domestic product (GDP). Aggregate supply is normally measured and reported over a year. It is also referred to by economists and analysts as total output,

Aggregate supply is commonly affected by prices. Rising prices generally indicate that businesses should expand production to meet a higher level of aggregate demand. When demand increases amid constant supply, consumers compete for available goods and pay higher prices. This dynamic induces firms to increase output to sell more goods. The resulting supply increase causes prices to normalize and output to remain elevated.

A shift in aggregate supply can be attributed to many variables. They include:

• Changes in the size and quality of labor
• Technological innovations
• Wage increases
• An increase in production costs
• Changes in producer taxes and subsidies
• Changes in inflation

Some of these factors lead to positive changes in aggregate supply while others cause a decline in aggregate supply. For example, increased labor efficiency, perhaps through outsourcing or automation, raises supply output by decreasing the labor cost per unit of supply. By contrast, wage increases place downward pressure on aggregate supply by increasing production costs.

Aggregate Supply Over Time

Short Run

Aggregate supply responds to higher demand (and prices) in the short run by increasing the use of current inputs in the production process.

The level of capital is fixed over shorter periods. This means that a company cannot do certain things, such as erecting a new factory or introducing a new technology to increase production efficiency.

Instead, the company ramps up supply by getting more out of its existing factors of production, such as assigning workers more hours or increasing the use of existing technology.

Long Run

Over the long run, aggregate supply is not affected by the price level and is driven only by improvements in productivity and efficiency. Such improvements include increases in the level of skill and education among workers, technological advancements, and increases in capital.

Certain economic viewpoints, such as the Keynesian theory, assert that long-run aggregate supply is still price elastic up to a certain point. Once this point is reached, supply becomes insensitive to changes in price.

Aggregate Supply vs. Aggregate Demand

Aggregate supply is the opposite of aggregate demand. While aggregate supply is the total amount of goods and services that producers are willing to sell to consumers, aggregate demand refers to the total amount of demand for finished goods and services in the economy over a specified time. It is expressed as a dollar value of how much consumers spend on these products.

Aggregate demand includes a variety of products, including:

• Consumer goods
• Capital goods
• Imports and exports
• Government spending programs

You can calculate aggregate demand by adding together the total amount of consumer goods, private investment, government spending, and net exports (exports less imports).

Several factors affect the aggregate demand in the economy. They include interest rates, foreign exchange rates, inflation, and income levels.

Example of Aggregate Supply

Here's a hypothetical example to show how aggregate supply works. Let's assume that XYZ Corporation produces 100,000 widgets per quarter at a total expense of $1 million, but the cost of a critical component that accounts for 10% of that expense doubles in price because of a shortage of materials or other external factors.

In that event, XYZ Corporation could produce only 90,909 widgets if it still spends $1 million on production. This reduction would represent a decrease in aggregate supply. In this example, the lower aggregate supply could lead to demand exceeding output. That, coupled with the increase in production costs, is likely to lead to a rise in price.

The Bottom Line

Aggregate supply is defined as the total number of goods and services that producers make and are willing to sell at a certain price within a certain time. Changes in supplies can affect demand and how the economy functions. Aggregate supply allows businesses and other entities to make key decisions about their financial situations, budgets, and plans for the future.