What Determines Potential Output?
Aggregate demand and supply
What you will learn
- Potential output depends on resources and productivity.
- Identify determinants of productive capacity
Essential definitions
- Long-run aggregate supply
- Sustainable real output determined by resources, productivity and institutions after relevant input prices adjust.
- Natural rate of unemployment
- The unemployment rate consistent with equilibrium in the labour market, including frictional, structural and seasonal unemployment.
Capacity in the long run
Potential output is the output an economy can sustainably produce with normal use of its resources. It is not an absolute physical maximum: overtime and intensive machine use can temporarily take actual output above it. Some job-search, skills-mismatch and seasonal unemployment can remain at potential. Together these form the course's natural rate of unemployment.
In the neoclassical model, wages and other input prices eventually adjust. A higher selling-price level then no longer gives firms a lasting profit incentive to produce beyond their resource capacity. Long-run aggregate supply, LRAS, is therefore vertical at potential output, Yp. The diagram has real GDP horizontally and the price level vertically; LRAS identifies capacity rather than demand.
How capacity grows
More workers, better skills, additional capital equipment and improved technology can raise sustainable output. Reliable infrastructure and effective institutions help resources work together. Clear property rights and predictable administration can support investment. Productive efficiency means obtaining more output from existing inputs.
For a lasting increase, draw LRAS1 at initial potential output and LRAS2 to its right. A worker returning to an existing idle machine raises actual output without necessarily shifting LRAS. A new, more productive machine can increase capacity. Population growth helps only when people can participate productively and have complementary resources.
Compare the diagrams and time horizons
A production possibilities curve, PPC, uses quantities of two goods on its axes. An outward frontier means more feasible production, the same capacity idea shown by a rightward LRAS shift. In the Keynesian AS diagram, capacity growth moves the steep full-capacity boundary right. Neither diagram promises that demand will use the new capacity immediately.
Productivity gains can reduce unit costs now and expand capacity later, shifting both SRAS and LRAS. A temporary fall in fuel prices may mainly shift SRAS. Damage to infrastructure or resource depletion can reduce potential output. State the mechanism and time period instead of shifting every supply curve for any favourable news.
Hypothetical capacity growth
- Potential real GDP rises from 800 to 832 billion base-year currency units.
- Capacity growth = (832 − 800) ÷ 800 × 100 = 4%.
LRAS shifts right from 800 to 832 billion; actual GDP need not immediately reach 832 billion.
Potential growth and long-run supply
LRAS moves from Yp=100 to Yp=120. Holding AD P=180−0.8Y fixed, the long-run price level is 84 at exactly the new potential output. The adjusted SRAS₂ passes through that long-run equilibrium; the adjustment path is not instantaneous.
More or better factors, technology and stronger institutions increase sustainable capacity. LRAS moves right. The final long-run equilibrium is on the new LRAS, not beyond potential output.
How to draw it and model assumptions
- Draw vertical LRAS₁ and LRAS₂.
- Intersect each with AD to mark initial E1 and new E2 at their respective capacities.
- Distinguish higher capacity from a temporary movement toward existing capacity.
New-classical long run: flexible input prices and output at potential. AD is held fixed to isolate the supply change; actual growth also depends on demand.
Actual growth versus potential growth
A → B uses existing capacity. B → C is feasible after a 20% outward expansion of the frontier. Output need not automatically reach C.
Moving from an interior point toward a production possibility frontier uses idle resources: actual growth. An outward frontier shift raises possible production: potential growth. Society need not immediately use that capacity.
How to draw it and model assumptions
- Label quantities of capital and consumer goods on separate axes.
- Show A inside the initial PPC and B on it.
- Draw a second PPC outside the first and label a feasible new production point C.
Two composite goods with fixed technology/resources per frontier; increasing opportunity cost. Coordinates are hypothetical annual output indices.
Long-term shifts of Keynesian AS
Capacity rises from 120 to 144. AD remains P = 180 − 0.8Y. Initially Y=108.33, P=93.33; after the capacity change Y=119.39, P=84.49. On the rising segment AS₂ is P = Y/1.2 − 15.
Investment in productive capacity moves the rising and full-capacity portions of Keynesian AS right. At a given level of AD, output can be higher and price pressure lower; in a deep recession an increase in capacity alone may leave actual output unchanged.
How to draw it and model assumptions
- Draw the initial three-section AS curve.
- Move the bottleneck and vertical capacity sections right to show more capacity.
- Keep AD fixed and compare initial E1 with new E2.
Fixed AD, hypothetical capacity expansion with the flat-section price floor unchanged. Idle resources and sticky input prices persist in the low-output segment.
Apply and evaluate
- Supply-side improvements can take years and depend on implementation quality.
- Long-run self-adjustment may be impeded by wage rigidity, weak confidence or persistent demand shortfalls.
Common misconceptions
- Full employment does not mean zero measured unemployment: frictional, structural and seasonal components may remain.
- An outward shift of LRAS is different from an AD-led recovery toward unchanged potential.
Knowledge check
Does doubling all prices and money wages double long-run output?
Real-world application
Energy costs and aggregate supply
16 November 2022: ONS reported that gas and electricity prices made the largest upward contribution to the change in UK annual consumer-price inflation between September and October 2022.
Model application: dearer energy can raise firms’ unit costs, shifting SRAS left. It also reduces households’ purchasing power, which can weaken demand. The observation alone does not identify the size of either shift or prove all inflation had one cause.
ONS, Consumer price inflation, UK: October 2022 ↗Historical evidence checked 9 October 2026. The model interpretation is an original teaching application.
What to remember
Potential output depends on resources and productivity. A sustained increase in capacity shifts LRAS right; stronger spending alone only changes how fully existing capacity is used.
Completion is your own reflection on learning, not a test score. Syllabus references: 3.2.10, 3.2.13.
Lessons in this section
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