IBEconomicsDPSLRevision Notes3. Macroeconomics3.7 Supply-Side Policies3.7.1 An Overview of Supply-Side Policies

An Overview of Supply-Side Policies (DP IB Economics)

Revision Note

Steve Vorster
DP Economics: SLDP Economics: HL

Introduction to Supply-side Policy

  • Supply-side policies aim to shift the long-run aggregate supply (LRAS)

  • There are two categories of supply-side policies

    • Interventionist and market-based

  • Interventionist supply-side policies require government intervention in order to increase the full employment level of output

    • These are mainly used to correct market failure

  • Market-based supply-side policies aim to remove obstructions in the free market that are holding back improvements to the long-run potential

    • E.g. Setting up a regulator to prevent monopolies from forming

The Goals of Supply-side Policy

  • Supply-side policies can be extremely useful in generating long term growth, lowering average price levels, and creating new jobs in an economy

     

3-7-1---goals-of-supply-side-policies-1

The five goals of Supply-side policy
  

  • When successful, supply-side policies have the following effects on the government's macroeconomic objectives

  1. Economic growth: potential national output increases leading to higher real gross domestic product (rGDP)

  2. Inflation: a greater supply in the economy results in reductions in the prices of goods/services leading to disinflation and making the exports of the nation more competitive

  3. Unemployment: this should fall as lower wage bills allow firms to recruit more workers

  4. Net external demand: due to the increased supply, the prices of goods/services often decrease which makes them relatively more attractive to foreigners - so exports increase

  5. Redistribution of income: this often worsens with the use of supply-side policies as wages fall and government tax revenue has fallen too 

Market Based Supply-side Policies

  • Market based supply-side policies aim to free up markets and improve market incentives so as to increase the long-run aggregate supply
     

An Explanation of Market Based Supply-side Policies


Market based policy


Explanation


Possible effects on the aims of supply-side policy

To increase incentives

  • Reducing income/corporation tax rates incentivises workers to work harder (they keep more money for themselves) and provides firms with extra funds which they can use to invest in new machinery/technology

  • Reducing capital gains tax

Taxes decrease → firms and individuals retain more money for themselves → incentives increase → productivity improves → long term growth increases

To improve competition and efficiency

  • Deregulation. Any regulation increases costs of production for firms and deregulation decreases costs which may result in greater supply

  • Privatisation. Government firms are usually so big that private enterprise refrains from trying to compete with them. Privatisation encourages new firms to enter the market and compete, thus increasing the aggregate supply in the economy

  • Anti-monopoly regulation helps to increase competition in an economy which leads to a more efficient allocation of resources

Regulation on firms decreases → the cost of production for firms falls → firms lower selling prices → international competitiveness improves

State owned firms are privatised → more firms enter the market to compete → competition and efficiency improves

To reduce labour costs and create labour market flexibility

  • Decreasing trade union power so wages can be decreased

  • Decreasing or abolishing minimum wages to lower costs of production

  • Restructuring the unemployment benefits system to incentivise the unemployed to seek work

Wages decrease → the cost of production for firms falls → firms lower selling prices → international competitiveness improves

 

The possible impact of abolishing minimum wages

  • A national minimum wage (NMW) is a legally imposed wage level that employers must pay their workers

    • It is set above the market rate

    • Removing it will allow wage levels to fall, thus reducing the costs of production for firms

3-5-3--minimum-wage_edexcel-al-economics

Removing the national minimum wage (NMW1) may cause wage rates to fall from W1 to We

 

Diagram Analysis

  • The demand for labour (DL) represents the demand for workers by firms

  • The supply of labour (SL) represents the supply of labour by workers

  • The national minimum wage and quantity for truck drivers in the UK is seen at W1Qd

  • The UK government removes the national minimum wage (NMW) at W1

  • Incentivised by lower wages, the demand for labour by firms increases from Qd → Qe

  • Facing lower wages, the supply of labour by workers decreases from Qd → Qe

  • The labour market is now in equilibrium at WeQe - a lower wage rate and higher quantity of workers employed

Interventionist Supply-side Policies

  • Interventionist supply-side policies require government intervention in order to increase the full employment level of output
     

An Explanation of Interventionist Supply-side Policies


Supply-side Policy


Explanation


Possible effects on the aims of supply-side policy

Education and training

  • Increasing government spending on education and retraining raises the quality of the workforce resulting in productivity improvements

Skill level increases → productivity improve → the cost of production for firms falls → firms lower selling prices → international competitiveness improves

Improving quality, quantity and access to health care

  •  Increasing government spending on healthcare so that productivity improves

Human capital improves → productivity improves → the cost of production for firms falls → firms lower selling prices → international competitiveness improves

Research and development

  • Increased government spending on innovation increases the supply of potential jobs in the economy

A new industry emerges → new infrastructure is developed → more jobs are created → r.GDP increases → increase in long term economic growth

Provision of infrastructure

  • Increased government spending on infrastructure helps to facilitate the movement of people and goods which increases the aggregate supply

New infrastructure is developed → costs of production decrease → supply increases → firms lower selling prices → international competitiveness improves

Industrial policies

  • Industrial policies are direct and targeted support to firms or industries in the form of subsidies 

Industries receive subsidies → costs of production decrease → supply increases → firms lower selling prices → international competitiveness improves

Examiner Tip

Essay questions will test your ability to differentiate between market-based and interventionist supply-side policies.

When evaluating supply-side polices in essay responses, demonstrate critical thinking by acknowledging that privatisation has been used for so long that there is often relatively few assets left to privatise and perhaps a better way forward is to improve competition policy and regulation.

Remember, the private sector will also be increasing supply in an economy (it is not only up to the government) as they are incentivised to increase their profits.

Diagrams to Illustrate Supply-side Policies

  • Successful supply-side policies will increase the long-run aggregate supply (LRAS)

    • This equates to an increase in the production possibilities of an economy

  • The successful implementation can be illustrated on either a Classical or Keynesian diagram

2-4-3---changes-to--lras---classical

A Classical diagram that illustrates the implementation of a successful supply-side policy 

2-6-3-supply-side

A Keynesian diagram that illustrates the implementation of a successful supply-side policy


Diagram Analysis

  • Efforts to reduce trade union power have been successful

    • There is now less protection on wage levels and wage levels fall

  • Firms may hire more workers and the quantity of productive labour in the economy has increased

    • This causes LRAS1 to increase to LRAS2  

      • Output increases from YFE to YFE1

      • Average price levels fall from AP1→AP2

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