2.3.2 - Short-run AS

Costs Drive SRAS

SRAS slopes upward because, as firms expand output, marginal costs tend to rise, so firms need a higher price level to make extra production worthwhile. So a change in the price level causes a movement along the existing SRAS curve. But the bigger exam issue here is what happens when firms' costs change for reasons other than current output: that shifts the whole curve.

If production becomes more expensive across the economy, firms are willing to supply less at every price level, so SRAS shifts left. If production becomes cheaper, firms can supply more at every price level, so SRAS shifts right.

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Read the shift from SRAS1 to SRAS2 in two linked ways. At the original price level PL1, firms now supply less real output than before. Equally, to produce the old output Y1, firms would now need a higher price level than before to cover those higher costs. Both readings capture the same mechanism. With aggregate demand unchanged, the economy moves from E1 to E2: the price level rises from PL1 to PL2 and real output falls from Y1 to Y2.

Raw Materials and Energy

Raw materials and energy are essential inputs for huge parts of the economy, so changes in their prices can shift SRAS significantly. Oil is especially important because it affects direct fuel costs for transport, energy bills for heating and machinery, and the price of petrochemical inputs such as plastics. The same logic applies to other commodities: higher steel prices raise costs for construction and manufacturing, higher agricultural prices raise costs for food producers, and higher copper prices raise costs for electronics firms.

When these input prices rise, firms face higher costs at every level of output. Production is less profitable at each price level, so firms supply less and SRAS shifts left. If input prices fall, the reverse happens and SRAS shifts right because production becomes cheaper.

Economists often call a sudden large change in production costs a supply-side shock, or supply shock. These shocks are often linked to geopolitical disruption to commodity supplies, natural disasters that reduce production, or sudden changes in global demand for key resources. When the shock pushes costs up, it can create cost-push inflation: prices rise not because aggregate demand is booming, but because supplying output has become more expensive.

The 1970s oil crises and the UK's 2022 energy shock are strong examples. In 1973-74 the price of crude oil roughly quadrupled, and in 2022 UK CPI inflation peaked at 11.1% in October. In both cases, sharply higher energy prices raised costs for factories, transport firms, retailers, and service businesses, so the effect was economy-wide rather than confined to one industry.

Exchange Rates and Import Costs

The exchange rate is the price of one currency in terms of another, and it matters because the UK imports large quantities of raw materials, fuel, components, and finished goods. If the pound depreciates, those imports become more expensive in sterling terms, so production costs rise for UK firms.