Definition of supply-side policy

Supply side policies are a series of long-term government policies designed to boost the economy’s potential productive capacity by improving the quality and/or quantity of production factors.

Goals of Supply-side Policies

1. International competitiveness (low inflation)
2. Competition and efficiency
3. Labor market flexibility
4. Incentives (to invest and innovate)
5. Productive capacity

PPC – Long Term Growth & Increase In Economy’s Productive Capacity

AD-AS Analysis

Interventionist supply-side policies

Interventionist supply-side policies assume that the free market economy cannot alone deliver the desired goals in terms of growing potential output, and argue that government intervention in certain sectors is necessary.

Investment in human capital: education and health services

Improved training and education lead to higher quality of labor resource, which increases productivity and drives economic growth. Government intervention can also reduce unemployment by implementing retraining programs, for example, state-funded on-the-job training, grants, and subsidies can also help workers relocate to areas with higher labor demand. Additionally, providing job information and implementing government projects in poor areas can create new employment opportunities.

Investment in new technology

Research and development (R&D) is crucial for developing new technologies that result in higher capital goods and potential output. Governments spend extensively in R&D, sometimes offering tax breaks and patent protection to private sector companies. This leads to increased aggregate demand in the short term and potential output in the long term, shifting the LRAS or Keynesian AS curves to the right.

Investment in infrastructure

Infrastructure, a form of physical capital resulting from investment, includes power, telecommunications, roadways, and urban transportation networks. Investment in infrastructure can result to increased efficiencies in production at lower costs. Effective telecommunications enable faster communication, boosting economic activity. Improved infrastructure also improves labor productivity. Therefore, infrastructure not only increase aggregate demand in the short term but also contribute to potential output which leads to AS increasing over the long term.

Industrial policies

Industrial policies are government policies that promote the expansion of an economy’s industrial sector. These strategies include investments in human resources, new technology, and infrastructure. They also include support for small and medium-sized firms through tax exemptions, grants, low-interest loans, and business advice. These approaches promote efficiency, capital formation, employment opportunities, and aggregate demand. Additionally, they support emerging industries, such as ‘infant industries’, in developing countries, through grants, subsidies, tax exemptions, and tariffs.

Market-based supply-side policy

Market-based supply-side policies are intended to make markets more efficient. This method allows the private sector greater control in resource allocation. They concentrate on liberalizing industries and improving market incentives in order to boost aggregate supply in the economy.

1. Encouraging competition

Competition reduces costs, improves production efficiency, and allocates resources more effectively. This can increase the quality of goods and services by allocating inefficient resources to more productive activities, increasing potential output, and shifting the LRAS curve to the right.

Privatisation

Privatization, or the transfer of ownership from the public to the private sector, can boost competitive efficiency by improving management and operations. This is because government enterprises frequently have complex procedures, large administrative costs, and inefficient employees who lack incentives to cut costs and maximize earnings.

Deregulation

Deregulation is the removal of government regulation of private sector activity, which some argue stifles competition and promotes inefficiency. There are two major types of regulation: economic and social. Economic regulation is the process by which the government controls pricing, output, and other activities in order to safeguard against competition. Many countries have deregulated their economies over the previous two to three decades, allowing new private enterprises to enter monopolistic or oligopolistic industries in order to increase efficiency, cut costs, and improve quality. Social regulation shields consumers from the negative consequences of private sector activities like food safety, worker protection, and environmental management. Some economists believe that social regulation should be lowered due to excessive bureaucratic procedures and unneeded government intervention.

Private financing of public sector projects

Historically, public sector projects like roads, airports, and schools have been funded by the government through tax revenues. However, in recent years, some nations have adopted private financing initiatives, where private corporations create, finance, and operate public services. The government purchases these services from the private enterprise, boosting competition. This approach allows private sector firms to compete for government selection, with the government choosing the firm that offers the lowest cost and highest quality services.

Outsourcing (contracting out to the private sector)

Contracts with the government allow private corporations to supply governmental services such as information technology, human resource management, and accountancy. As enterprises fight for contracts, this leads to more competitiveness, improved efficiency, cheaper production costs, and quality, all of which result in better overall performance.

Restricting monopoly power

Enforcing anti-monopoly legislation, splitting up giant corporations into smaller units, and prohibiting mergers can boost competition by restricting monopoly power, dividing monopolistic firms into smaller units that behave more competitively, and avoiding mergers that could result in excessive monopoly power. This can result in better efficiency, reduced costs, and higher quality.

Trade liberalization

Trade restrictions have been reduced in recent decades, allowing for more open international trade between countries. In the coming chapters, you will learn that free trade promotes rivalry among enterprises, leading to increased production efficiency and resource allocation.

2. Labor market reforms

Labour market reforms, often known as improving flexibility or reducing rigidities, seek to improve competitiveness, align pay with supply and demand, reduce labor costs, and boost employment by lowering unemployment. These reforms can result in lower production costs, higher profitability, increased firm investment, enhanced R&D, and capital goods production, all of which can lead to potential output and economic growth. These measures are critical for combating structural unemployment and eliminating labor market rigidities.

Abolishing minimum wage legislation

Reducing/eliminating minimum wage legislations can decrease unemployment by lowering the equilibrium wage, leading to increased wage flexibility, lower unemployment, greater firm profits, increased investment, and economic growth by allowing firms to hire more labor at lower wages.

Weakening the power of labor (trade) unions

Unionized labour often secures high wage increases. If labor unions weaken, wages will be more responsive to supply and demand, leading to unemployment and increased wage flexibility, similar to abolishing minimum wage legislation. Ways government weaken the power of labor unions:

• Legislation and Regulation: can enact laws that restrict union activity, such as limiting the right to strike, setting limits on collective bargaining, or making it more difficult to form unions through severe registration procedures.
• Anti-Union Campaigns: Some governments or businesses may launch efforts to discredit unions, portraying them as barriers to economic growth or obsolete institutions.
• Automation and Technological Advancements: Encouraging industries to use automation and new technologies can lessen the demand for human labor, reducing unions’ negotiating power.
• Legal Challenges: Legal challenges to union policies, such as lawsuits against strikes or union activities, can limit their strength and effectiveness.
• Promotion of Alternative Labor Organizations: Governments may fund or encourage other forms of labor representation, such as company-sponsored worker councils or professional groups, which may compete with traditional unions.

Reducing unemployment benefits

Unemployment benefits are payments made to workers who lose their jobs to provide them with income while they look for work. However, they may lower job-search incentives, resulting in extended unemployed durations. Reducing unemployment benefits may reduce unemployment by encouraging the unemployed to seek employment, thereby lowering the natural rate of unemployment.

Reducing job security

Many countries have laws shielding employees against termination, making it expensive for businesses to fire them due to their high pay. Reducing job security by making it easier and less expensive for businesses to fire employees can boost employment, lower labor costs, and contribute to higher profitability, investment, and economic growth. This is because companies are more likely to hire new employees if they can simply dismiss them.

3. Incentive-related policies

Incentive-related policies seek to cut various kinds of taxes, which may affect the incentives that taxpayers, including businesses and consumers, face.

Lowering personal income taxes

Changes in personal income taxes can affect aggregate demand, according to supply-side economists. These improvements can result in higher after-tax wages, increasing the number of persons employed. This can also lead to more hours worked each week, higher interest in seeking work, longer working years, and lower unemployment. These conditions can cause the LRAS curve to move to the right, which increases potential output. Therefore, lowering personal income taxes help decrease unemployment and increase the number of persons seeking job.

Lowering taxes on capital gains and interest income

Many governments impose taxes on capital gains, profits from investments such as stocks and bonds, and interest on savings deposits. Reducing these taxes may enhance motivation to save, resulting in more savings available for investment. This, in turn, would increase the creation of capital goods and potential output.

Lowering business taxes

Lowering taxes on business earnings can raise aggregate demand by encouraging investment spending. According to supply-side economics, larger after-tax profits provide enterprises with more financial resources for investment and technical innovation, resulting in higher potential production.

Evaluating supply-side policies

Time lags

Supply-side policies, both interventionist and market-based, have considerable time lags that affect aggregate supply in the long run due to time-consuming activities such as increased competition, labor market reforms, and investments. However, interventionist measures have a short-term impact on aggregate demand, potentially helping to close recessionary gaps. However, they can contribute to destabilization in an inflation-stricken economy by increasing inflationary pressures.

Increases in potential output

Long-term economic growth is primarily driven by investments in capital and new technology, which result in greater labor productivity. Institutions with incentives and a market system encourage growth, allowing the private sector to operate efficiently. Supply-side policies seek to attain these goals, and economists generally believe that they play an important role in raising potential output.

Arguments for interventionist policies

Economists argue over whether interventionist or market-based policies are more effective at increasing potential production. Interventionist policies give benefits such as focused government support in sectors such as investment, R&D, training, and education, which market-based policies may not supply as effectively. Industrial policies enable the government to assist industries that have the highest growth potential. The Asian Tigers, a group of countries that experienced rapid growth through interventionist policies, are used as examples. However, several developing countries implemented market-based supply-side strategies in the 1980s, resulting in questionable economic performance.

Arguments for market-based policies

Market-based policies contend that government intervention can lead to inefficiencies and resource misallocation, whereas reliance on the market can result in long-term growth. Critics believe that government intervention can lead to less efficient solutions due to political pressures, a lack of information, and unforeseen consequences. They also claim that governments may not select the appropriate industries to assist, resulting in inefficient resource allocation. Supporters of market-based policies also point out that interventionist programs rely heavily on government spending and divert resources that could be better used elsewhere. High taxes and a large government sector can discourage workers and increase inefficiency, limiting the effectiveness of market-based programs.

Debate over incentive-related policies

Tax cuts are contentious market-based policies because they have uncertain consequences on employment, savings, and potential output growth. They have both demand-side and supply-side effects, though some economists debate the strength of the latter. Increases in disposable income as a consequence of personal income tax reduction may lead to people working less, spending more money on leisure, or saving less. Savings in the United States have fallen to their lowest level in 80 years, and economists dispute on whether tax cuts introduced as supply-side measures worked. Overall, the impact of tax cuts on employment, savings, and potential production growth remains debatable.

Ability to create employment

Supply-side policies seek to create jobs by lowering the natural unemployment rate, which incorporates structural, frictional, and seasonal causes. Interventionist policies, like as investments in education and training, can have a direct impact on unemployment reduction by allowing people to learn new skills, offering relocation aid, and providing information that decreases unemployment when workers are between jobs or seasons. Individuals who have received further education and training are more likely to get employment.

Market-based policies, such as labor market reforms, can help to reduce unemployment by making the labor market more responsive to supply and demand. However, market-based policies that promote competitiveness may raise unemployment in the near run. Privatization, for example, can result in job losses for both the government and the country as a whole if projects are outsourced to corporations in lower-cost countries. Economic deregulation has also resulted in higher jobless rates due to increased competition.

In conclusion, while supply-side policies can create jobs, they may not always reduce cyclical unemployment. Instead, they can help to reduce unemployment in the long run as the economy gains from the broader effects of supply-side measures.

Ability to reduce inflationary pressure

Supply-side strategies, whether interventionist or market-based, are expected to reduce inflationary pressures in the long run by increasing potential output and shifting the LRAS curve to the right. As an economy grows, aggregate demand and supply may not significantly rise, allowing for a balanced price level. These strategies also focus on reducing firms’ production costs through increased efficiency and labor costs due to enhanced market flexibility.

Impact on the government budget

Interventionist and incentive-related market-based policies negatively impact the government budget, but for different reasons. Interventionist policies increase government spending, adding to the budgetary load. Incentives use tax cuts, reducing government income, potentially creating a budget deficit or worsening an existing one.

Effects on equity

Equity is the distribution of income among persons, and supply-side policies have varying effects on equity. Interventionist policies that prioritize expenditures in human capital, such as education, skills, and health, are likely to produce long-term benefits for equity. These strategies lower inequality by providing money to formerly unemployed workers.

Market-based policies tend to have a negative impact on equity because increased competition may result in some unemployment and a loss of income. Labour market reforms, such as minimum wage legislation, can weaken worker protection and increase job insecurity, contributing to rising income inequality.

Incentive-related measures, such as tax cuts, can exacerbate income inequality. High taxes discourage people from working and saving, particularly those with higher incomes. To address this issue, tax cuts must be tailored to harm higher-income groups’ after-tax incomes, making the tax system less progressive and lessening the redistributive effects of individual income taxes.

Prices set by private enterprises can also have an impact on income distribution. If they have market power, they may raise prices to cover government costs and limit output, making their products less accessible. This can have a negative impact on lower-income groups, especially if they offer essentials or valuable items such as utilities. Subsidized provision of merit goods is a technique for redistributing money in favor of higher economic equality, although privatization has the potential to undermine it.

This problem is especially severe in developing countries, where privatization of services has rendered them costly for the poorest citizens.

Effects on the environment

Market-based policies such as privatisation and deregulation may have a negative influence on the environment since they enhance the scope for activities, resulting in negative externalities. However, the government can mitigate these consequences by adjusting or lowering the external costs of private sector activity.

Evaluating Government Policies To Deal With Unemployment & Inflation

Unemployment Policies

Cyclical unemployment

Cyclical unemployment is caused by low or declining aggregate demand, and solutions to address it include expansionary demand-side policies such as fiscal and monetary policy. These strategies seek to boost real GDP while reducing the recessionary gap, resulting in lower cyclical unemployment. The virtues and weaknesses of these policies are equally applicable to resolving cyclical unemployment.

Financial policy has advantages, such as bringing an economy out of a prolonged recession and the direct effect of government spending on aggregate demand. However, it has flaws such as time delays, political limits, crowding out, and the inability to fine-tune the economy. Automatic stabilizers, such as progressive income taxes and unemployment insurance, can assist minimize cyclical unemployment during a recession.

Monetary policy has advantages such as rapid implementation and incremental adjustments to interest rates, central bank independence, and no crowding out. However, it has flaws such as time lags, possible inefficiency in a deep recession, and conflicting government interests.

When assessing the success of fiscal and monetary policies, economists should take into account their relative merits. For example, unless the economy is in extreme recession, monetary policy is likely to be chosen over fiscal policy because of its relative advantages. Supply-side measures cannot address cyclical unemployment.

Natural unemployment

Structural unemployment is the most severe type of natural unemployment, and economic strategies aiming at reducing it largely address this issue. Supply-side strategies are ineffectual in addressing this issue because they can increase inflation and result in temporary unemployment drops. However, fiscal policy can have a major impact on natural unemployment due to supply-side impacts.

Interventionist supply-side measures include establishing retraining programs, assisting with retraining through grants and low-interest loans, direct government hiring, grants to firms offering on-the-job training, subsidies to firms hiring structurally unemployed workers, and providing information on job availability in various geographic areas. Measures to reduce frictional unemployment seek to enhance information flows between businesses and job searchers, thereby minimizing the time a worker spends looking for work.

Seasonal unemployment measures include informing workers about jobs available during off-peak seasons in other industries. These policies have a direct positive influence on job growth while avoiding greater economic inequality and job insecurity. However, they have a detrimental influence on the government’s budget and the opportunity costs of spending.

Labor market reforms that promote labor market flexibility, such as lower minimum wages, weaker labor unions, decreased job security, and reduced unemployment benefits, are examples of market-based supply-side initiatives. These policies try to reduce the natural rate of unemployment without having a negative impact on the government budget, but they also lead to economic disparity and a loss of protection for low-income employees.

Inflation Policies

Demand-pull inflation

Demand-pull inflation is created by higher aggregate demand, which results in an inflationary gap. To address this, contractionary demand-side policies, including fiscal and monetary policy, seek to reduce aggregate demand and return the economy to potential production. These policies have advantages and disadvantages, including coping with quick and growing inflation, the direct impact of government spending on aggregate demand, and the potential to fine-tune the economy.

Monetary policy, on the other hand, has advantages such as rapid implementation and incremental interest rate adjustments, central bank independence, and the absence of political restraints. However, it contains flaws such as time lags, political limits, and conflicts between government goals.

Economists generally favor monetary policy over fiscal policy to address inflationary gaps because it offers relative advantages over fiscal policy. Because of the large time lag, supply-side policies cannot be utilized to address demand-pull inflation in the short term. However, over time, supply-side actions can lower inflationary pressures caused by demand by pushing the LRAS or Keynesian AS curves to the right.

Cost-push inflation

Cost-push inflation occurs when the cost of production rises due to supply-side shocks, resulting in a leftward shift in the SRAS curve. This leads in higher prices, lower real output, and more unemployment. Demand-side measures are ineffective in this situation because inflation necessitates a reduction in aggregate demand, whereas unemployment necessitates an increase in aggregate demand.

There are no general remedies for cost-push inflation. Governments may use contractionary monetary policy to reduce aggregate demand, but this might exacerbate the recession and raise cyclical unemployment. Other remedies vary depending on the precise cause of the cost increase. For example, if pay rises are causing cost-push inflation, supply-side policies can be used to slow or reverse wage increases.

If cost-push inflation is caused by a spike in the price of an imported input, such as oil, there are no simple solutions. Countries have attempted to address this issue by developing alternate energy sources and encouraging consumers to save money on oil-based items. However, these policies require time to take effect.

Another sort of cost-push inflation can occur when enterprises with significant monopoly strength boost their profits by raising their prices. Market-based supply-side strategies can be used to break up monopolies and promote competition. Another sort of cost-push inflation can occur when a country’s currency falls in value, causing an increase in the prices it must pay for imported commodities. Firms that rely heavily on imported inputs and raw materials face higher production costs, which contribute to cost-push inflation.

Inflation targeting

Inflation targeting is a monetary policy that seeks to maintain a specified inflation rate, independent of the underlying causes. It has been successful in keeping inflation low and stable, but it may limit its ability to fulfill other goals, such as low unemployment and responding to supply-side shocks. For example, if an oil price shock creates cost-push inflation and stagflation, keeping inflation low may result in a deeper recession and increased cyclical unemployment.

Simple Review Questions

1. (a) Describe the aims of supply-side policies. (b) What are the two types of supply-side policies, and how do they differ in their overall scope?
2. Using an appropriate AD-AS model diagram, depict and explain the expected effects of supply-side policies on real GDP, price levels, and unemployment rates. (You can use the Keynesian or neoclassical models to demonstrate.)
3. (a) Give examples of interventionist supply-side programs. (b) Use a diagram to demonstrate how these policies affect aggregate demand in the short term while simultaneously increasing LRAS. (c) How would you illustrate these impacts with the Keynesian AD-AS model?
4. Why do proponents of market-based supply-side policies say that by focusing on the supply side of the economy, policymakers can simultaneously handle economic growth, price stability, and unemployment?
5. What advantages do supply-side policies have over demand-side policies in the event of stagflation (simultaneous inflation, unemployment, and recession)?
6. Give examples of supply-side policies that try to achieve the following goals: (a) increasing competition, (b) improving incentives, and (c) making the labor market more responsive to supply and demand.
7. Explain the benefits and drawbacks of interventionist supply-side strategies, such as investment in human capital, infrastructure, and industrial policies.
8. Explain the benefits and drawbacks of market-based supply-side policies, such as (a) competition-enhancing policies, (b) labor market reforms, and (c) incentive-based policies.
9. (a) What policies do you advocate to address cyclical (demand-deficient) unemployment? Which policies do you not recommend? Describe the advantages and downsides of your policy ideas. (b) Respond to (a) in the case of structural, frictional, and seasonal unemployment.
10. (a) What policies do you advocate to address demand-pull inflation? Which policies would you not recommend? (b) Discuss the advantages and downsides of your policy ideas.
11. (a) What policies do you advocate to address cost-push inflation? Which policies would you not recommend? (b) Discuss the advantages and downsides of your policy ideas.

Past Paper Review Questions

Command Terms

References

• https://www.amazon.in/Economics-Diploma-Coursebook-Digital-Access/dp/1108847064
• https://www.amazon.com/Economics-Diploma-CD-ROM-Ellie-Tragakes/dp/0521186404
• https://www.cambridge.org/us/education/subject/business-and-economics/economics/cambridge-international-and-a-level-economics-3rd-edition/cambridge-international-as-and-a-level-economics-3rd-edition-coursebook-cd-rom?isbn=9781107679511
• https://www.amazon.com/Economics-IB-Diploma-Paul-Hoang/dp/1510479147
• https://www.ibdeconomics.com/uploads/1/1/7/5/11758934/ib_economics_-_command_terms.pdf

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