The lack of any long-run relation between the price level and real production occurs due to the flexibility of prices and wages. In other words, prices adjust to achieve equilibrium and eliminate all market shortages and surpluses. This long-run aggregate supply relation is illustrated by a vertical long-run aggregate supply curve and can be better understood with a look at full employment and what happens when the price level rises or falls.

The Long-Run Aggregate Supply Curve

Long-Run Aggregate Supply Curve

• First, the price level is measured on the vertical axis and real production is measured on the horizontal axis. The price level is usually measured by the GDP price deflator and real production is measured by real GDP.


• Second, the long-run aggregate supply curve, labeled LRAS, is a vertical line. The aggregate real production offered for sale by the business sector is the same at higher price levels as it is at lower price levels. This constant level of aggregate real production is full-employment production.


• Third, the price level and aggregate real production are the only two variables allowed to change in the construction of this curve. Everything else that could affect long-run aggregate supply is assumed to remain constant. Analogous to market supply, these other variables are ceteris paribus factors that fall under the heading of aggregate supply determinants.


• Fourth, this long-run aggregate supply curve captures the relation between the price level and the flow of real production over a given time period. However, depending on the particular aggregate market analysis, the time period could be shorter (several months) or longer (several years). Of course, if the time period is too short, then the long-run aggregate supply curve might not be relevant.

Full Employment

In principle, full employment is the condition that exists when all resources are engaged in production. In practice, however, this condition is not necessarily achieved. An economy ALWAYS has some unemployed resources, particularly frictionally and structurally unemployed resources.

• Frictional unemployment results because resources are in the process of moving from one production activity to another, which does not happen instantaneously. The time needed to match up resources with production depends on the availability of information and the degree of geographic separation.


• Structural unemployment results because resources, especially labor, are configured (trained) for a given technology but the economy demands goods and services using another technology, the productive capabilities of the resources do not match the requirements of the productive activities.

This market equilibrium notion of full employment means that resource prices reach equilibrium levels and do not change. There are NO shortages or surpluses in resource markets to prompt changes in resource prices. This lack of change in resource prices goes hand-in-hand with the notion of long-run price flexibility. In other words, resource prices have adjusted as much as needed to eliminated market imbalances. No imbalances persist and further price changes are not forthcoming. (Unless determinants shock the system and create new imbalances.)

The key implication is that the long-run aggregate supply is ALWAYS equal to full-employment production. It matters not what the price level is, it can be high, it can be low, full-employment production is maintained. In the long run, the economy never produces more or less than full-employment production. Producing more or less than full-employment production is a short-run phenomenon, not a long-run one.

Price Adjustments

Consider how and why long-run aggregate production and the employment of resources are not affected by changes in the economy's price level.

• A Lower Price Level: First, consider a reduction in the price level. Individual firms react to lower prices according to the basic microeconomic principles of short-run production, including the law of supply and law of diminishing marginal returns. Each firm reduces production by employing fewer resources. When aggregated for the macroeconomy, total production declines and so too does the employment of resources, in the short run.
  
  However, the short run decline in production and resource employment occurs because ALL prices have not yet adjusted to equilibrium levels. In particular, resource markets are out of balance. The quantity of resources demanded is less than the quantity of resources supplied. This causes market surpluses and creates unemployment. While these resource market surpluses can persist in the short run due to inflexible prices, in the long run, flexible prices decline to eliminate the unemployment surpluses and achieve equilibrium.
  
  In particular, wages and other resource prices decline as much as the price level declines. If the price level falls by 10 percent, then wages and other resource prices ALSO decline by 10 percent. This equal proportional decline in prices ensures that the purchasing power of wages and other resource prices are the same after the price level decline as before the decline. This is important because real wages and real resource prices are the keys for determining the quantities of resources demanded and supplied. Employers hire workers based on real wages paid and workers take jobs based on real wages received.
  
  Because real resource prices are at their full-employment equilibrium levels BEFORE the price level decline and real resource prices are the same after the price level decline as they were before, then resource markets are at their full-employment equilibrium levels. The aggregate real production supplied AFTER the price level decline is exactly the same as BEFORE the price level decline. The decline in the price level has absolutely no affect on the aggregate real production.


• A Higher Price Level: Now, consider what happens with a price level increase. Individual firms react to higher prices, once again, according to the basic microeconomic principles of short-run production, including the law of supply and law of diminishing marginal returns. Each firm increases production by employing more resources. When aggregated for the macroeconomy, total production increases and so too does the employment of resources, in the short run.
  
  However, the short run increase in production and resource employment occurs because ALL prices have not yet adjusted to equilibrium levels. Once again, resource markets are out of balance. The quantity of resources demanded is greater than the quantity of resources supplied. This causes market shortages that triggers overemployment of resources by reducing frictional and structural employment and temporarily enticing resources to increase productive efforts. While this overemployment and overproduction can persist in the short run due to inflexible prices, in the long run, flexible prices rise to eliminate the shortages and achieve equilibrium.
  
  In particular, wages and other resource prices rise as much as the price level increases. If the price level increases by 10 percent, then wages and other resource prices ALSO increase by 10 percent. This equal proportional increase in prices ensures that the purchasing power of wages and other resource prices are the same after the price level increases as before the increase. This is important because real wages and real resource prices are the keys for determining the quantities of resources demanded and supplied. Employers hire workers based on real wages paid and workers take jobs based on real wages received.
  
  Because real resource prices are at their full-employment equilibrium levels BEFORE the price level increase and real resource prices are the same after the price level increase as they were before, then resource markets are once again at full-employment equilibrium levels. The aggregate real production supplied AFTER the price level increase is exactly the same as BEFORE the price level increase. The increase in the price level has absolutely no affect on the aggregate real production.