In this lesson, let's turn now to the upward sloping aggregate supply curve in our aggregate supply–aggregate demand model. This curve shows that the level of real GDP or domestic output that will be produced at each price level, again holding other things constant. And as I have noted, the aggregate supply curve slopes upward simply because higher price levels create an incentive for businesses to produce and sell additional output while lower price levels reduce output. And, like the aggregate demand curve, the aggregate supply curve can shift in or the aggregate supply curve can shift out depending on various factors. Now, before we go over the various factors that may shift the aggregate supply curve inward or outward, I want to point out one key difference between a shift in the aggregate demand curve versus a shift in the aggregate supply curve. Let me illustrate this key difference with this figure. In the left-hand graph, I have illustrated an outward shift in the aggregate demand curve while in the right-hand graph, I've illustrated an outward shift in the aggregate supply curve, and you can see that in both cases, real GDP has increased by exactly the same amount, Q star minus Q, indicating more economic growth. Now, here's another at least slightly tricky question for you. If you were the benevolent dictator of the economy represented in these two figures, which scenario would you prefer as a way of seeing the real GDP rise in your country? Please think carefully about this for a minute and then jot down your answer before moving on. Okay. Which scenario would you prefer to increase real GDP growth by an equivalent amount? An outward shift of the aggregate demand curve or an outward shift of the aggregate supply curve? Well, looking at the figure, you would clearly prefer the shift in aggregate supply. This is because you not only get more growth, you also get a lower inflation rate as the price level falls from P to P star, and both of these factors are very bullish for your country. In contrast with an aggregate demand shift, you do indeed get more growth but you also get more inflation as the price level rises, which is a problem that you as a dictator will likely have to deal with. In fact, this single observation about the superiority of aggregate supply shifts when it comes to stimulating growth while reducing inflation, captures the essence of a third school of economics we have yet to mention, that of supply side economics. We'll talk more about supply side economics in a future lesson but for now, let's quickly run through the various factors that may lead to supply side shifts as represented in this figure. Here, we see three broad categories of shift factors. The first category is that of the prices of so-called factor inputs into the production process like land, labor, capital and energy. The second category of shift factors includes elements of the business-government environment such as legal, regulatory and tax policies. And the third category captures the state of a nation's technology and related rates of innovation and productivity. So, take a minute now to study this figure before we move on to some examples. Remember, as you study this figure, that these shift factors are the other things we are holding constant when we draw the aggregate supply curve. So, as you study this figure, try to imagine how each factor might affect the aggregate supply curve. One of the most important lessons of micro economics is that businesses need land, labor and capital to produce and sell products. So, which way will the aggregate supply curve shift if for example oil prices rise in the macro economy? Say, because of increased conflict in the Persian Gulf region where much of the world's oil is produced. And with this aggregate supply curve shift, what will be the effect on the general price level and GDP growth? Take a minute now to draw the ASAD model and use it to answer this question. Does your figure look like this? In this case, a rise in the price of a key factor like labor will shift the supply curve inward. The result will be a lower real GDP as Q falls to Q star. But note, there is also an increase in the inflation rate with the slower growth from P to P star. This is a classic case of what economists call cost push or supply side inflation. In this case, an energy price shock has not only increased inflation, it has also caused real GDP to fall. And this is a particular type of situation that if persistent, can lead to stagflation, simultaneous inflation and slow growth. As we shall see in a later lesson, stagflation is one of the hardest macro economic problems to deal with because it simply cannot be dealt with and cured with traditional fiscal or monetary policy actions. In some countries, the government is business-friendly. In other countries, the government and business have an adversarial, sometimes hostile relationship. But in all countries, a change in the legal, regulatory or tax rules can have profound effects on the business government environment and the aggregate supply curve. To drive this point home and to end this lesson, take a look at the following two scenarios. Those of a payroll tax cut and a tightening of environmental regulations. How will the aggregate supply curve be affected? Just check the appropriate box in your head or on a piece of paper. And here's a twist. As a voter in your country, which of the two scenarios would you support? And why? When you'll finish jotting down your thoughts, let's move on for some answers. Okay. For starters, any cut in the payroll tax will shift the aggregate supply curve out and boost real GDP. The downside of course is that the government may not have enough revenues to for example, build new infrastructure. So, that over time that lack of infrastructure may negatively affect GDP, and that's something you as a voter may want to consider when you vote for candidates promising to cut taxes. As for tightening of air and water pollution standards, that will shift the aggregate supply curve in and cause both slower growth and more inflation, however, both the air and water will be cleaner. And that's one of the tough choices societies and democracies in particular have to make. In this key definition, productivity is defined as total output divided by total inputs. As we shall learn more about in a future lesson, one of the biggest drivers of increased productivity is technological change; new hardware, new software, new machines and new ideas that allow countries to get more out of their existing resource base for less. So, which way do you think the aggregate supply curve will shift if productivity increases? And why? Clearly, if productivity increases, the average production cost of a unit of output will fall, and this will cause the aggregate supply curve to shift outward. Most broadly, this is because increases in productivity increase the potential output of an economy. That's precisely why it is so important for businesses and universities to innovate and bring about technological change as well as things like innovations in management practices and industrial processes that will boost productivity. Well, that's it for this lesson in the aggregate supply aggregate demand model of the classical economists. In the next class, we will introduce the equally useful and insightful Keynesian model. Broader goal of that lesson will be to use the Keynesian model to explore the mysteries of one of the most important real world policy tools in macroeconomics, that of fiscal policy. So, take a breather now and recharge your batteries, and I'll see you again soon. From the Merage School of Business, University of California, Irvine, I'm Peter Navarro.
