Difference between SRAS and LRAS

This article will help you to learn about the difference between SRAS and LRAS.

Difference between SRAS and LRAS

Thus we see that aggregate supply behaves differently in the short run and long run.

This gets reflected in the behaviour of firms. Firms raise both prices and output in the short run as aggregate demand increases. In contrast, increases in aggregate demand lead to price changes with little, if any, change in output in the long run.

These result may apparently appear to be puzzling, if not subversive. The puzzle can be solved by analysing the behaviour of wages and prices in a modern market economy. Some elements of business costs are inflexible or sticky in the short run. For this reason, firms can make profit from higher levels of aggregate demand by expanding their output levels.

In the long run, a different type of behaviour is observed. Eventually, the inflexible (sticky) elements of cost — wage contracts, rent agreements, regulated prices, and so forth — become unstuck (flexible) and thus negotiable. Firms are not able to take advantage of fixed-money wage rate in their labour agreements forever. Sooner are or later workers are able to recognise that prices have gone up.

So they demand compensating increases in wages. Ultimately all costs get adjusted to the higher output prices. If the aggregate price level rises by x% because of higher demand, then, nominal wages, rents, regulated prices and other costs items will — in the end — respond by moving up by almost x%.

Once costs have increase as much as prices, firms will be unable to profit from the higher level of aggregate demand. In the long run, after all elements of cost have fully adjusted, firms will face the same ratio of price to costs as they did before the increase in aggregate demand.

So they will have hardly any incentive to increase their output. The LRAS, therefore, tends to be vertical. This simply means that output supply has no relation to the level of prices and costs.

To sum up, aggregate supply will differ from potential output in the short run because of inflexible elements of costs. In the short run, firms will respond to higher demand by raising both production and prices. In the long run, as cost respond to the higher level of prices, most or all of the responses to increased demand takes the form of higher prices — with output remaining fixed at the potential (full employment) level.

Whereas the SRAS curve is upward sloping, the LRAS curve is vertical because, given sufficient time, all costs adjust.