IB STUDY

2.6 Supply side policies 

 

Supply side policies: these aim at positively affecting the production side of an economy by improving the institutional framework and the capacity to produce (that is, by changing the quantity and/or quality of factors of production).

 

Therefore the LRAS shifts to the right, achieving growth in potential output. 

 

Market based policy: aims to allow markets to work more freely with minimal government intervention. 

 

Interventionist policy: government provides capital goods and services where it is believed that the market has failed to provide them. 

 

Interventionist supply side policies

 

 

Interventionist policy: this affects both AS and AD, as it involves government spending – a component of AD. Whilst it also increase productivity, total output and so AS.

 

Investment in human capital: investment in education and training will raise the levels of human capital and have a short-term impact on aggregate demand, but more importantly will increase LRAS.

 

This is because a more skilled workforce will improve their productivity and increase total output. 

 

• Training: the government may provide specific training centres or give subsidies to firms to help them train their workforce. Also it helps to retrain workers who have lost their jobs and need to adapt their skills in order to renter the labour market. 

 

• Education: as a merit good education is under provided and under consumed in a free market, so the government intervenes to supply free or subsidised education and regularly make changes to the curriculum and methods of delivery.

  Education provides skills and productivity to the workforce, therefore increasing total output.

 

• Healthcare: in some countries the public health is poor, so there are many absentees from school or work. Therefore, the government may intervene to provide free or subsidised healthcare.    

 

Investment in new technology: the government can actively encourage research and development by firms by offering tax incentives, such as not paying corporation tax when doing research and development.  They can also acts as sponsors for research and development programs.

 

Investment in infrastructure: large scale building projects increase the output of the economy as it becomes cheaper and easier to produce and transport finished products. Also it will make the labour more geographically mobile.  

 

Industrial policies: governments can have agencies that support and develop a specific industry.     

 

• Protection of infant industries: a government may use tariffs to protect small new firm that do not yet profit from economies of scale. Therefore, giving it an opportunity to expand to compete on the world market.       

 

• Financial incentives and advice for small firms: governments may provide financial incentives, like subsidised loans, reduced corporation tax rates, and direct subsidies. They may also provide advice on business start-up for firms and provide support in writing business plans etc.    

 

Evaluation of interventionist policies 

 

 

Budget constraints: the majority of these policies require large amounts of government spending and implementation of these policies may be limited by the government’s budget and their ability to borrow money. This spending also involves an opportunity cost in terms of what money could have been spent on instead.        

 

Time lags: the demand side effects of many of these policies might be felt quite quickly, however, the supply side effects may take many years to have an impact.        

  

Market based supply side policies

 

Policies to increase competition: greater competition results in greater efficiency, so a largest amount of output can be produced with the same amount of resources. Competition may also result in better quality, more innovative products and lower prices.      

 

• Privatisation: the sale of state owned industries to the private sector, as privately owned firms can be more efficient since they are more motivated to make profit.   So less resources are needed to produce the same amount output, as productivity increases, and the average costs of production fall.

 

• Trade liberalisation: this involves reducing barriers to international trade such as removing tariffs (tax on imports) and quotas. This encourages specialisation and trade and increases the number of goods and services available to consumers. 

 

• Anti-monopoly regulation: monopoly power gives producers the power to restrict output and force up prices. Anti-monopoly laws (anti-trust laws) seek to prevent domestic monopolies in the market. With increased competition there will be greater choice for consumers and usually lower prices.

 

• Deregulation: reducing the number and severity of the regulation on a business. This involves laws on a number of firms that are allowed to compete, health and safety laws, environmental laws etc. This reduces the costs of production for firms as they no longer have to spend time and money to comply with so many rules. 

 

Labour market reforms: designed to make the markets more responsive to supply and demand so that the level of employment will increase and productivity will rise. 

 

• Reducing trade union power: a trade union is a group of workers who act together to further their own interests with regards to wages and working conditions. They often result in wages above the equilibrium wage and lower levels of productivity. Policies designed to reduce their power should result in higher levels of employment, higher productivity and an easier process to make workers redundant. So workers will more between employers more easily.

 

• Reducing unemployment benefits: this encourages more people to accept jobs, especially even low paid jobs.

 

• Reducing the national minimum wage: this reduces the costs of labour so firms are able to hire more workers and produce more output.  

 

Incentive related reforms:

 

• Reducing corporate taxes:  (tax on firms’ profits) this gives firms more funds for investment. This could also be used for research and development which then improves technology advancement.

 

• Reducing income tax: may provide an incentive for workers to work harder and for longer hours as they get to keep a higher proportion of their income and so increase productivity. However, many individuals do not have the opportunity to alter their hours, as they are contracted to work a certain amount.  

 

As income tax is reduced, the real wage rate increases from P to P1. The Labour supplied then also increases from Q to Q1.   

 

 

Evaluation of market based policies

 

Increased inequality: these reforms may cause the low income earners and the unemployed to find their incomes falling relative to that of other members of society. The incentive based policy of cutting the income tax which is progressive in nature will also result in more inequality. 

 

Effects on tax revenue of cutting tax rates: the Laffer curve shows that a cut to tax rates could lead to an increase or decrease in tax revenue. 

 

Increasing the tax rate could increase tax revenue from R to R2 or decrease it to R1. 

 

Increased negative externalities: as a result of reduced regulation with regards to the environment and policies to increase competition this might result in an increase in the negative externalities of production. 

 

Evaluation of supply side policy

 

Supply side policies aim to increase the productive potential of the economy and shift the LRAS to the right.  

 

 

 

 

 

 

 

 

 

 

 

 

However, from the Keynesian perspective there is insufficient AD, an increase in AS will not result in an increase in real output and economic growth.