Understanding Aggregate Supply (Definition and Formulas)

By Indeed Editorial Team

Published April 26, 2022

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Economics studies the relationship between the supply of products in a marketplace and consumers' demand. The aggregate output supply is a critical element of a healthy economy. Learning about aggregate output can help you better understand the factors that affect an economy's total amount of available goods. In this article, we discuss the definition of aggregate supply, identify the factors that influence total output, highlight the formulas for calculating total production levels, and review an example of aggregate output.

What is aggregate supply?

Within economics, aggregate supply is the total amount of goods or services available in a particular market for a specific period. Also known as total output, it is the total amount of items producers can sell at a given price in an economy. There is a direct relationship between the number of goods and services producers can provide and the price of the items, which you can see by the supply curve. When shown on a graph, there is typically a positive relationship between the total output and the price levels in an economy.

Within a national economy, the gross domestic product measures total aggregate output. When reviewing total supply, there are two elements to consider, including short-run and long-run supply:

Short-run supply

Economists typically calculate total output supply over a year to compensate for changes in demand preceding changes in supply. This time frame is crucial, as it takes producers longer to adjust to increasing or decreasing demands. For example, a manufacturer may require more employees, materials, or production equipment. Similarly, when demand falls, a company adjusts its production capacity accordingly to reduce supply.

The influential factor for short-run supply is price. As the demand for a product or service increases in the marketplace, consumers are typically open to paying a higher price. To gain profits from higher prices, companies often increase supply until they reach their current capacity. As a result, short-term fluctuations can occur without affecting the long-run supply output.

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Long-run supply

Unlike the influence of prices on short-run supply, long-run output experiences change because of improvements in efficiency and productivity. Over time, a company can respond to increased marketplace demand with more permanent measures. When the need for a product increases, the short-term response is to increase production by increasing labour hours, for example. This is sustainable temporarily, but the company can make adjustments to accommodate the long-term demand over time.

For example, a company may increase its capital and add to its production facility. It can also invest in technological advancements, such as automation or new machinery. Another option includes improving the skill level of employees by offering intensive training and development programs to improve productivity and employee efficiency.

Factors of influence on aggregate output

Several factors directly influence the production and supply output a company can provide. Missing from the list is financial capital, as money is not a direct factor of production. Financial capital allows an organization to purchase the other factors, including workforce, capital goods, material resources, and business operations. A strong long-run supply requires abundance in all four areas:

Workforce

Companies that provide products and services to the marketplace rely on an abundant skilled workforce to operate an effective business. The value of a company's employees depends on their qualifications, skills, education, and work characteristics. In exchange for providing a workforce to the organization, the company offers a competitive wage. Many economic factors influence the availability of qualified workers, including national inflation, cost of living, and labour competition from other countries. If a company cannot secure a skilled workforce, its long-run supply can be negatively affected.

Companies can offer competitive wages and benefits, a positive working environment, and internal training programs to counteract this challenge. Labour directly affects output supply by influencing production costs. For example, suppose a company offers extensive training to boost employee productivity. As a result, labour efficiency increases, which raises supply output by decreasing the production costs for the goods manufactured. In contrast, suppose the same company increases employee wages. This creates downward pressure on total supply by rising production costs.

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Capital goods

Capital goods are man-made objects companies use to produce other goods and services, including machinery and equipment. Businesses rely on having the capital goods necessary for their operations to manufacture and deliver adequate marketplace supply consistently. For example, suppose a manufacturing company cannot access the machinery needed for its factory. As a result, its long-run output supply is negatively affected, as an increase in labour or material resources is unsustainable. In contrast, when a company can purchase capital goods required, it can increase production levels, increasing its total supply output.

An example of how a company can use capital goods to its advantage is purchasing additional equipment for a manufacturing plant. By investing in automated machinery or computerized systems that streamline the manufacturing process, the company can reduce the production costs of its supply over time. A decrease in cost can positively impact the total supply output.

Material resources

Material resources include the raw goods a company uses to create market supply. A company requires abundant resources to have a long-term and sustainable business model. If raw materials are unique or limited, the price in the market reflects the restriction on material availability. Resource limitation also affects the total supply that a company can produce, potentially decreasing the supply curve.

An example of how a company can use material resources to its advantage is by the physical location of its operation. For example, suppose a business manufactures wooden furniture. The company opens its manufacturing location near several logging mills, allowing for minimal costs on material transportation. It is also near a major trucking route and warehousing facilities, increasing the productivity of supply chain management.

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Business operations

Business operations directly affect a company's aggregate output. The drive of an organization's leadership to innovate and provide goods and services to the marketplace is essential to the total supply output it offers to consumers. Without entrepreneurship, the market economy no longer has a driving force to produce. Many elements create a company's operations that support total supply output, including hiring practices, training and development of its employees, and internal policies and procedures that streamline manufacturing processes.

For example, a company can invest in a research and development department to create innovative new products for the marketplace. They can also develop streamlined processes for all company employees to follow, helping to increase efficiency and productivity. Each element of business operations directly influences the total production that contributes to the aggregate output.

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Aggregate output curve

You can show the relationship between the price level in the marketplace and the production output on a graph known as the aggregate supply curve. There are two equations that economists use to determine the total outcome for short and long-run supply:

Short-run supply equation

When you graph short-run market supply, the curve is an upward slope. The upward slope happens because the supply increases in a direct relationship as the price increases. To calculate short-run supply, the formula is:

Y = Y + a (P - Pe)

Within the formula, the constant represented by "a" allows the calculation to show how much output can change because of deviation in the price levels. In this equation:

  • Y represents the production of the economy or short-run supply

  • Y represents the natural level of production of the economy

  • a represents a constant coefficient greater than zero

  • P represents the price level

  • Pe represents the expected price level from marketplace consumers

Long-run supply equation

In contrast to short-run supply showing as a sloping, curved line, you see long-run supply as a vertical line on a graph. Economists use this specific formula because the assumption is that the production economy uses everything optimally. Any changes to demand can influence long-run supply temporarily, and, as a result, the curve is static. To calculate long-run supply, the formula is:

Y = Y

In this equation:

  • Y represents the production of the economy or long-run supply

  • Y represents the natural level of production of the economy

Example of aggregate output

To better understand the concept of aggregate supply, consider the following example:

Northwood Manufacturing produces stainless steel check valves at its production facility. Every quarter, the company manufactures 100,000 valves at a total production cost of $1,000,000. Recently, the cost of a critical component that accounts for 10% of the total cost doubles in price because of a shortage in raw materials. As a result, Northwood Manufacturing can only produce 90,909 valves with the exact $1,000,000 cost. Because of the decrease in supply, there's the possibility of consumer demand exceeding total output. As a consequence of decreased supply and increased production costs, the economy can expect to experience a price increase.

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