Supply is the willingness and ability of producers to generate the output of some good or service at various prices in a specific time period. Aggregate supply is a much broader concept than supply because it is inclusive of all domestic production, not just a singular good or service. Like an individual firm, an economy has a production function that relates the amount of labor employed with the amount of output or real GDP that the economy can produce with some fixed level of capital. In the short run, the amount of real GDP supplied is directly related to the price level. However, in the long run, the amount of real GDP producers collectively supply is independent of the price level.
The Short Run
Why do firms respond in the short run to price-level increases by producing more output and vice versa? Before answering this question, it's important to recall what is meant by short run in the macroeconomic sense. The short run is the period of time in which input prices (primarily nominal wages) do not adjust to price-level changes. If the economy experiences unexpected inflation, the short run is the period in which money wages remain fixed before finally adjusting to the inflation. During this period, firms realize higher profits as their output earns ever-higher prices while they maintain the same wage payments to their workers. Firms respond to the higher profits by increasing their collective output, or real GDP. In response to decreases in the price level, firms reduce output as they experience losses. This relationship is called the short-run aggregate supply (SRAS).
The Long Run
In the long run, the price level is irrelevant to the level of real GDP firms are willing to produce. The long run is the period of time in which input prices adjust to changes in the price level. Unlike the short run, where increases in the price level induce more output, in the long run firms do not realize higher profits and thus have no incentive to increase output. Why? Input prices match the increases in the price level. Therefore, in the long run, firms' input prices (wages) increase at the same rate as general price inflation and in real terms are constant. The independence of real GDP from the price level is referred to as long-run aggregate supply (LRAS).
Changes in SRAS
SRAS is affected by changes in per-unit production cost. As per-unit production costs fall, the economy is able to produce more real GDP at every price level, and as unit costs rise, the economy's ability to generate real GDP is reduced. In true economic style, per-unit production costs themselves are subject to influence by productivity, regulation, taxes, subsidies, and inflationary expectations. Productivity is output per worker and as it increases, per-unit costs fall. Decreases in productivity lead to higher per-unit production costs. Regulations place compliance costs on business and act to reduce SRAS. For example, to reduce sulfur dioxide emissions, factories must pay for smokestack scrubbers, which means that money cannot be used to increase output. Taxes on producers directly reduce their capacity to produce while subsidies increase their productive capacity. Finally, inflationary expectations influence the unit costs of production and therefore SRAS. As inflationary expectations increase, workers demand higher wages, lenders demand higher interest rates, and commodity prices increase as a result of speculation. The outcome is for SRAS to be reduced by inflationary expectations. Decreases in inflationary expectations have an opposite effect and serve to increase SRAS.
Changes in LRAS
LRAS is directly influenced by the availability of the factors of production. If land, labor, capital, and entrepreneurship increase, then LRAS increases. Decreases in the availability of these resources reduce the LRAS. Increases in LRAS are characterized as economic growth. Decreases in LRAS represent a long-term economic decline. The medieval black plague that wiped out a third of the European population is an example of an event that reduces LRAS. The invention of the steam engine exemplifies the type of technology that expands the LRAS.