The Aggregate Supply Curve and Potential GDP
Firms make decisions about what quantity to supply based on the profits they expect to earn. In turn, profits are also determined by the price of the outputs the firm sells and by the price of the inputs, like labor or raw materials, the firm needs to buy. Aggregate supply (AS) refers to the total quantity of output (i.e., real GDP) firms will produce and sell. The aggregate supply (AS) curve shows the total quantity of output (i.e., real GDP) that firms will produce and sell at each price level.
Figure 10.3 shows an AS curve. In the following paragraphs, we will walk through the elements of the diagram one at a time: the horizontal and vertical axes, the AS curve itself, and the meaning of the potential GDP vertical line.
The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level. Remember that the price level is different from the inflation rate. Visualize the price level as an index number, like the GDP deflator, while the inflation rate is the percentage change between price levels over time.
As the price level—the average price of all goods and services produced in the economy—rises, the aggregate quantity of goods and services supplied rises as well. Why? The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy—like the GDP deflator—not the price level for intermediate goods and services that are inputs to production. Thus, the AS curve describes how suppliers will react to a higher price level for final outputs of goods and services, while holding the prices of inputs like labor and energy constant. If firms across the economy face a situation where the price level of what they produce and sell is rising, but their costs of production are not rising, then the lure of higher profits will induce them to expand production.
The slope of an AS curve changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the AS curve, the level of output in the economy is far below potential GDP, which is defined as the quantity that an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions. At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time, or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—while making the assumption of no rise in input prices—can encourage a considerable surge in the quantity of AS because so many workers and factories are ready to swing into production.
As the quantity produced increases, however, certain firms and industries will start running into limits: perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running at full speed. In the intermediate area of the AS curve, a higher price level for outputs continues to encourage a greater quantity of output—but as the increasingly steep upward slope of the AS curve shows, the increase in quantity in response to a given rise in the price level will not be quite as large. Read the following Clear It Up feature to learn why the AS curve crosses potential GDP.
Clear It Up
Why does aggregate supply cross potential GDP?
The AS curve is typically drawn to cross the potential GDP line. This shape may seem puzzling: How can an economy produce at an output level which is higher than its potential or full employment GDP? The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: All workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully, to using them in a way that is not sustainable in the long term. Thus, it is indeed possible for production to sprint above potential GDP, but only in the short run.
At the far right, the AS curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output, because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed. In this example, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low—at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.