At first, long-run aggregate supply (LRAS) is perfectly elastic, real GDP increases without any inflationary pressure. This is because there is spare capacity. Resources are underutilized or unemployed so firms can employ more resources without bidding up their prices so firms’ costs and prices do not rise.
LRAS then becomes inelastic, both real GDP and the price level increase. This is because spare capacity is running out, resources are becoming scarce so there are bottlenecks (supply shortages). To obtain more resources, firms must bid up resource prices so firms’ costs and prices rise.
LRAS then becomes perfectly inelastic, the price level rises but real GDP stays the same. This is because the economy is at full capacity, all resources are fully employed, no more output can be produced. Firms must offer higher prices to tempt resources away from their current use. All that happens is firms’ costs rise so prices rise but aggregate output stays the same (the composition of output just shifts from some firms to others).
An increase (decrease) in LRAS shifts LRAS right (left), there is an increase (decrease) in the productive capacity of the economy because the economy can produce more (less).
Many factors could increase LRAS:
1) Raw Materials.
As raw materials become cheaper, costs of production fall, so firms can increase production. A fall in world demand for resources, or a rise in the value of the domestic currency means the price of imported raw materials falls.
2) Investment.
An increase in investment raises the stock of capital (machinery) so the economy can produce more.
3) Technological Advance.
Research and Development (R&D) leads to improved technology, machines become more efficient so more can be produced with the same amount of resources.
4) Education.
An increase in education raises human capital, labour skills improve and labour becomes more efficient, so output per worker rises.
5) Labour Market Flexibility.
As the labour market becomes more flexible, unit labour costs fall so production rises. Also, migrant labour means more labour is available so more can be produced.
6) Red Tape.
A reduction of red tape by the government makes firms more efficient so they can produce more.