2.6.3 Supply side policies – Edexcel Economics notes

Defining supply side policies

Supply-side policies increase the productive potential of the economy.

There are two types of supply-side policies:

• Market-based supply side policies aim to make markets more competitive and increase incentives to work. This includes privatisation and income tax cuts.
• Interventionist supply side policies involve government intervention. For instance, government spending on education or infrastructure.

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Basic diagrams for supply side policies

Supply-side policies, as they increase productive potential, shift the LRAS to the right.

Interventionist supply side policies, as they involve an increase in government spending, can also shift AD to the right.

This can also occur for market-based supply-side policies. For instance a cut to income taxes may boost disposable income, increasing consumption and AD as a result.

Market-based supply side policies

Key points for market based supply-side policies:

• Policies to increase incentives:
  • Income tax cuts
    • Cutting income tax rates increases the incentive to work. So workers may work more hours. Higher pay might also increase worker motivation, leading to higher productivity
    • Also more workers may enter the labour force, as the post-tax income from working is now more likely to exceed any welfare payments.
    • This all contributes to long-run aggregate supply shifting to the right.
    • You can also argue that the increase in labour supply, as well as the rise in labour productivity, leads to a fall in business costs per unit produced. This shifts SRAS right.
    • Cutting income tax also raises the disposable income of households. This is likely to increase consumption and also aggregate demand.
    • Also government revenue may fall. This reduces the funding available for public services such as national defence or education.
    • Alternatively tax cuts could increase the budget deficit and lead to more government borrowing. This drives up debt interest payments.
  • Corporation tax cuts
    • Corporation tax cuts reduce the tax rate on firms’ profits. This gives firms more funds to reinvest, increasing investment and AD.
    • Corporation tax cuts also increase the future rate of return on any investment made today. A firm knows that any future profits made will be taxed at a lower rate. This increases the incentive to invest today, boosting AD.
    • Higher investment boosts the quantity and quality of the capital stock. This raises productive capacity, shifting the LRAS right.
    • This also increases firms’ incentive to grow or the incentive to start a business. This shifts LRAS right.
    • Investment from abroad may also increase.
    • However again government revenue may fall, reducing funding for public services such as education or national defence.
    • Cutting corporation tax may have less of an impact on firms making low profits or even losses.
    • Other countries may respond to corporation tax cuts in one country by lowering their own corporation tax rates. This could lead to a race to the bottom in corporation tax rates. As a result, cutting corporation tax rates may not attract much additional investment from abroad.
  • R&D tax credits
    • R&D stands for research and development.
    • R&D tax credits give firms a reduction in their tax bill when they spend money on R&D.
    • This increases incentives to invest in new capital, boosting productive capacity and shifting LRAS right.
  • Reduction in welfare spending
    • Welfare spending refers to government spending on welfare benefits, for instance unemployment benefit.
    • Reducing unemployment benefit increases the incentive to work.
    • This also reduces the extent of the unemployment trap.
      • The unemployment trap is where being unemployed and claiming welfare benefits leads to a higher income than working, reducing incentives to work.
      • Reducing the extent of the unemployment trap means more workers enter the labour force.
      • This increases the productive capacity of the economy, as there is a greater quantity of labour available.
    • Lower welfare payments may also reduce the budget deficit. This lowers the amount of government borrowing, so debt interest payments will be lower.
    • However reducing the level of welfare benefits may increase poverty and inequality. People on welfare benefits may not be able to afford the necessities for living, such as rent, food, water and energy costs, if welfare benefits are cut. This could also increase the level of homelessness.
    • Those unemployed may cut their job search short too early, settling for one job when there may be another job that better matches their skills available in the future.
• Policies to promote competition:
  • Privatisation is selling a state-owned company to the private sector.
    • An example of privatisation is privatising Royal Mail in the UK.
    • Private firms may be motivated by profit. This may be reinforced by the incentive for firms to survive. A publicly owned company can make losses and the shortfall is made up extra by government spending. However if a private company consistently makes losses, it can go out of business. This incentivises firms to cut costs and increase productivity to survive and raise profits.
    • Privatisation may drive up investment, as there are greater profits from which to fund investments. However investment may fall, if the firm has a shorter term view than the government or cuts investments to save on costs in the short term.
    • However this may decrease employment, particularly in the short run as a privatised firm seeks to cut costs by laying off workers.
    • Privatised firms may maximise profits while publicly owned companies are more likely to maximise social welfare. This means taking into account any externalities caused by the company’s production, for instance pollution, in setting the quantity produced. However a privatised firm might not take such externalities into account, leading to environmental damage.
  • Deregulation is reducing the amount of paperwork for firms.
    • An example of deregulation is the deregulation of airlines in the 1970s. This encouraged new entrants, including budget airlines selling cheaper plane tickets.
    • Existing firms benefit from lower costs from reduced regulation. Firms can reassign workers away from paperwork towards production.
    • Deregulation may lead to lower barriers to entry. This encourages new firms to enter the market, leading to greater total production and higher productive capacity.
    • More firms in the market may also create greater competition, increasing aggregate supply and lowering the price level.
    • Lower firm costs from complying with regulation lead to higher profits. Higher profits may lead to more funds to invest. So investment may rise.
    • However regulations may be there for a reason. This could include protecting workers’ rights, preventing fraud or protecting the environment. By removing such regulations, workers or the environment may be worse off as a result.
  • Other policies to promote competition include breaking up large companies and blocking mergers.
• Restrictions on trade union activity.
  • A trade union is a group of workers aiming to protect workers’ rights. This includes protecting pay, conditions and promoting worker training.
  • This could include increasing the minimum turnout requirement of workers for a strike vote to be valid. This was part of the Trade Union Act 2016 in the UK, making it more difficult for workers to go on strike.
  • Making it harder to strike could increase productivity, as work is less likely to be interrupted by strike activity.
  • Disruption may also be reduced outside or the firm whose workers are striking. For example, a train strike may reduce productivity for firms whose workers commute by train, as their workers may not be able to reach work.
  • However this makes it more difficult for workers to negotiate wages. This may lead to lower wages, which can reduce the incentive to work and reduce productivity.
  • Lower wages for workers could also increase the level of poverty. Inequality could also rise, particularly if firms benefit from higher profits as a result of lower wages.
  • Trade unions can also play a role in encouraging worker training.
  • Trade union density (the percentage of workers in a trade union) varies by sectors. So for many private sector companies, with trade unions already weak, further trade union restrictions may not have much of an effect.
• Reducing labour market regulation such as removing minimum wages or making it easier to hire and fire workers.
  • Making it easier to hire and fire workers reduces the costs to firms of hiring workers. Firing without notice also means the firm does not have to keep on employees whose productivity is low. So firms can increase their overall productivity.
  • To the extent that firms’ costs fall, firms can increase their profits and use the funds for investment. This will increase aggregate demand.
  • However removing minimum wages or deregulating labour markets may lead to lower wages and job insecurity.

Interventionist supply side policies

General points for interventionist supply side policies

• Often these policies make workers and firms more productive, shifting LRAS to the right.
• Higher government spending also shifts AD right. This generates a multiplier effect.
• Yet there is an opportunity cost of government spending on interventionist supply side policies. This government spending could go elsewhere for instance on national defence. In this case, higher government spending on supply side policies may mean forgoing spending on national defence.
• There can also be time lags. The policy may take time to have its full effect. In particular, the AD effect is more likely to occur in the short term. However the supply side effect on the LRAS could take up to decades depending on the particular policy (education, infrastructure). This can make these policies inflationary in the short run.

Specific points for interventionist supply-side policies:

• Government spending on education or training
  • Example: £2.6 billion of government spending on the National Skills Fund for adult education and training in the UK.
  • This increases workers’ level of human capital. Human capital refers to workers’ skills. This increases productivity and shifts LRAS right.
  • This might encourage workers who have left the labour force to retrain and enter the labour force again.
  • However time lags for education spending may be significant. It takes time to learn new skills and to find jobs where those skills can be in use.
  • Also, any education or training must target skills that are in demand. If the training teaches skills that are not in demand, those workers will struggle to find jobs, so these workers may become or remain unemployed.
  • There is no guarantee that people will take up any training offered.
• Infrastructure spending
  • An example of infrastructure spending is building a new train or underground line. For example, the Elizabeth Line on the London Underground.
  • Infrastructure can also include bus routes and internet connections.
  • Providing a new train line reduces travel time for some workers. So less time is lost on the commute to work. So workers can spend a greater number of hours at work (or waste less time on commuting). This may boost the productive potential of the economy.
  • There may be reduced transport costs for transporting inputs. This reduces firm costs, so SRAS shifts right.
  • Workers can access a greater range of jobs. So workers may find a job that better matches their skills, so they can be more productive in their job. This shifts LRAS to the right.
  • The increase in government spending on infrastructure boosts AD. It can also create a multiplier effect, as construction workers receive higher incomes and spend that extra money in their local communities. This further increases AD.
  • However, there has been a rise in the proportion of workers working on computers or remotely. This may reduce the demand for infrastructure spending on new train lines, as people may be less in need of travel when meetings can be held remotely.
  • There may be a significant time lag associated with infrastructure spending in particular. The majority of HS2 is expected to be completed in 2033.
  • Opportunity costs can also be an issue with infrastructure. Infrastructure projects often run over budget too, further increasing the opportunity cost of spending on infrastructure.
• Other examples are increasing government spending on healthcare or childcare.

Extra analysis and evaluation points for supply side policies

Diagrams:

• When we think of supply-side policies, we usually draw a diagram showing the LRAS shifting right.
• You can also add to these diagrams. Where supply side policies will also lead to lower business costs, the SRAS will also shift right. The LRAS shift and SRAS shift could be shown on the same diagram for a 25 marker.
• When LRAS and/or SRAS shift, there is a movement along the AD curve.
  • For example, deregulation lowers business costs and may boost productivity. This shifts LRAS and SRAS right. This lowers the price level, improving export competitiveness, which leads to a movement along the AD curve.
  • It is important not to confuse AD shifts with movements along the AD curve.
• In addition, supply-side policies can shift AD as mentioned above. Interventionist supply-side policies involve a rise in government spending, which shifts AD right, for example.
  • To extend the discussion of AD shifts following a change in government spending, investment or net exports, consider discussing the multiplier effect.
• The balance between AD and LRAS effects matters. If a supply-side policy shifts AD more than it shifts LRAS, then it may end up being inflationary. This is especially likely to occur in the short run, as the effect on the LRAS may take time to occur.

Macroeconomic objectives

• Supply-side policies, by shifting LRAS, lead to a lower price level and higher real GDP. This means supply-side policies help achieve the key four macroeconomic objectives: sustained economic growth, full employment, price stability, and by lowering export prices, export competitiveness and hence reducing the size of any current account deficit.
• For interventionist supply-side policies, these policies require higher government spending upfront. This can increase the budget deficit and lead to higher debt interest payments.
  • The level of debt interest payments depends on the level of interest rates. If interest rates are low, this lowers the cost of debt interest, reducing the extent to which the budget deficit rises. For example in 2020 Bank rate in the UK fell to 0.1%, making borrowing cheaper.
  • Moreover over time, such policies can pay for themselves. For instance, raising the quality of education increases human capital, boosting future wages, which will raise future tax revenue.

Practice question on supply side policies

Here is a practice question written in the style of Edexcel A Economics A Level. There is a short extract followed by a practice 25 mark question.

The UK Government plans to remove planning laws, making it easier to build homes, infrastructure and AI data centres. This includes making it easier to build on brownfield sites, more use of “grey belt” land including unused car parks, as well as removing regulatory barriers to developments in towns and cities across the UK.

Evaluate the macroeconomic effects of market-based supply-side policies such as deregulation. (25 marks)

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