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Aggregate Supply: What It Is, How It Works

The 4 Factors of Production, Supply Curve, Law of Supply and Demand



Labor is an important component of supply.

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Aggregate supply includes all goods and services produced in a country.

Credit: Stephen Chiang/Getty Images
Aggregate Supply: What It Is, How It Works

The U.S. has been blessed with a lot of natural resources, including oil.

Photo: Getty Images

Aggregate supply is defined as the total of all goods and services produced by an economy over a certain period of time. When people talk about supply in the U.S. economy, they are usually referring to aggregate supply, and the typical time frame is a year.

This time frame is important, because supply usually changes more slowly than demand. For example, when demand for a good rises, it takes a while for companies to ramp up production. When demand drops, it can takes months for companies to reduce supply, because it means closing factories and laying off workers.

That's why there's a big difference between supply in the short-run versus the long-run. Short-run supply depends on price. As demand rises, customers are willing to pay a higher price. Businesses will increase supply to gain the profits from higher prices until they reach their current capacity.

In the long-run, if the price and demand stay high, businesses can supply even more as they add workers, machinery and factories. (Source: Tutor2U.net, Aggregate Supply)

Factors of Production

The factors of production determine the total amount that can be supplied. This amount is called the natural rate of output. Supply that's more or less than this is called short-run economic fluctuations. The U.S. has been blessed with an abundance of the factors of production, thus allowing American companies to produce about 20% of the world's supply. There are four factors that determine long-run supply:
  1. Labor -- The people who work for a living. The value of labor depends on workers' education, skills and motivation. The reward or income for labor is wages. The U.S. has a highly skilled and mobile labor force that can respond quickly to changing business needs. However, it's facing more competitive labor from other countries. For more, see Why American Jobs Are Being Outsourced.
  2. Capital Goods -- Man-made objects, such as machinery and equipment, that are used in production. The U.S. has been a technological innovator in creating capital goods, from airplanes to robots. The income derived from capital goods is interest.
  3. Natural Resources -- The raw goods and materials used by labor to create supply. The U.S. has been blessed with a unique combination of easily accessible land and water, moderate climate, miles of coastline and, in this century, lots of oil. The income for this is rent.
  4. Entrepreneurship -- The drive of business owners to produce and innovate. The income for this is profits.
Financial capital, such as money and credit, is not a factor of production because it's used to buy the factors of production. In other words, it isn't itself a component of anything produced. However, the ease of obtaining financial capital, whether through stocks, bonds or loans, plays a critical role in supply. One of the reasons the U.S. economy is so powerful is the ease of obtaining financial capital. (Source: St. Louis Federal Reserve, Factors of Production)  

Aggregate Supply Curve

The supply curve charts out how much will be supplied based on the price. Here's how it works. If someone asks you, "How much will you supply?" you would first ask them, "How much will you pay me?" and if that answer were satisfactory you'd want to know, "How long have I got?" In other words, your answer would vary depending on the price and the time frame. That is essentially what is described in a supply curve. The higher the price and the longer the time frame, the more you would produce. That's why a normal supply curve slopes up to the right. An aggregate supply curve simply adds up the supply curves for every producer in the country.

Aggregate Supply and Aggregate Demand

Of course, you and the person would have to agree on the price and the time period. In other words, their demand curve would have to intersect with your supply curve. When all the demand for everything in the country is added together, that's the aggregate demand. Everything in an economy depends on how these curves intersect.

Law of Supply and Demand

The amount supplied is guided by the laws of supply and demand. The law of supply says that supply increases when the price increases. The law of demand says that demand decreases as the price increase. The right price is when the amount supplied equals the amount demanded.

In other words, an economy must follow these key rules:

  1. Supply must equal demand.
  2. Demand creates supply, but supply won't create demand.
  3. Prices adjust until supply equals demand.
  4. When prices decline, businesses eventually decrease supply OR they lower the cost to the output to maintain profit margins OR they go out of business, thus decreasing the output.
  5. When prices rise, businesses supply more in the short-term until they reach current capacity. In the long-run, they increase the factors of production so they can supply more. They may also create similar or related products to meet the demand.
  6. If supply is constrained, then prices will continue to rise, creating inflation.

What Does the U.S. Supply?

The amount supplied is the output, and it's measured by Gross Domestic Product, or GDP. The four components of GDP are:

  1. Personal Consumption, which is 70% of total supply. This includes goods, such as automobiles and appliances, and services, such as health care and banking.
  2. Business investment,such as machinery and equipment. This category also includes construction.
  3. Government spending, most of which is Social Security, Defense and Medicare.
  4. Net exports. Most of this is capital goods, such as machinery and equipment, and consumer goods, especially pharmaceuticals. For more, see Import/Export Components. Article updated July 18, 2014.
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