Chapter 32 - Supply-side policies Flashcards
What are supply-side policies?
A range of measures intended to have a direct impact on long-run aggregate supply - and specifically the potential capacity output of the economy
What are market-based supply-side policies?
Policies that rely on allowing markets to work more freely and providing incentives for enterprise and initiative
What are interventionist supply-side policies?
Policies by which the government intervenes to stimulate aggregate supply
How is privatisation and deregulation a market based policy?
In the past, some industries were taken into public ownership in the belief that this would protect consumers from being exploited. However, it was later realised that this was leading to inefficiency, because incentives and accountability for managers of these publicly owned enterprises were inadequate. Such enterprises have been sold back into the private sector through a process known as privatisation. This was intended to stimulate aggregate supply by improving efficiency, as managers became accountable to their shareholders, rather than to some government body or their customers. Similarly, there are situations in which industries have been over-regulated, and again, deregulation has been put forward as a supply-side policy on the grounds that regulation can tie the hands of a firm’s managers and provide weak incentives to achieve efficiency.
Neoclassical economists argue that if markets are free to operate without too much interference from government, there will be an improvement in productive efficiency, so that firms will be able to supply more output at any given price. This will have the effect of shifting the long-run aggregate supply curve (LRAS) to the right.
How is improved labour market flexibility a market based policy?
An important supply-side approach is to find ways of improving the flexibility of the labour market. Where labour markets are flexible, the structure of economic activity can more readily be adjusted to changing patterns of global demand. If declining low-productivity sectors can give way to more dynamic activities where productivity is higher, then productive efficiency improves, and this will lead to a rightward shift in the long-run aggregate supply curve.
One possibility is to limit the power of the trade unions, whose actions can sometimes lead to inflexibility, either through resistance to new working practices that could improve productivity or by pushing up wages so that the level of employment is reduced. It has also been argued that abolishing the minimum wage would improve flexibility. However, this must be balanced against the need to protect low-paid workers.
Maintaining the flexibility of markets is one way in which the macroeconomic stability promoted by disciplined fiscal and monetary policy can improve aggregate supply. Macroeconomic stability enables price signals to work more effectively, as producers are better able to observe changes in relative prices. This can promote allocative efficiency. The net effect of all this is again to shift the LRAS curve to the right.
How is reform of the tax and benefit system a market based policy?
Incentive effects are important in economic analysis. In this context, questions have been raised about the extent to which the tax system provides appropriate incentives to supply work effort.
There are dangers in having a taxation system that is too progressive. Most people accept that income tax should be progressive - that is, that those on relatively high incomes should pay a higher rate of tax than those on low incomes - as a way of redistributing income within society and preventing inequality from becoming extreme. However, there may come a point at which marginal tax rates are so high that a large proportion of additional income is taxed away, reducing incentives for individuals to supply additional effort or labour. This could also have an effect on aggregate supply. Again, however, it is important to balance these incentive effects against the distortion caused by having too much inequality in society.
An important influence on labour supply, particularly for low-income workers, is the level of unemployment benefit. If unemployment benefit is provided at too high a level, it may inhibit labour force participation, in that some workers may opt to live on unemployment benefit rather than take up low-skilled (and low-paid) employment. In such a situation, a reduction in unemployment benefit may induce an increase in labour supply, which again will move the aggregate supply curve to the right.
Such a policy needs to be balanced against the need to provide protection for those who are unable to find employment. It is also important that unemployment benefit is not reduced to such a level that workers are unwilling to leave their jobs to search for better ones, as this may inhibit the flexibility of the labour market.
How is education and training an interventionist policy?
An important interventionist supply-side policy takes the form of encouraging workers (and potential workers) to undertake education and training to improve their productivity and raise their human capital. This takes place partly through education in schools and colleges in preparation for work. It is important, therefore, that the curriculum is designed to provide key skills that will be useful in the workplace. However, this does not mean that all education has to be geared directly to providing skills. For example, problem-solving and analytical skills can be developed through the study of a wide range of disciplines.
Adult education is also important. When the structure of the economy is changing, retraining must be made available to enable workers to move easily between sectors and occupations. This is crucial if structural unemployment is not to become a major problem. For any society, education and skills are necessary to enable workers to switch into new activities in response to structural changes in the economy. For example, workers displaced from manufacturing industry are likely to need retraining if they are to find jobs in the service sector. Workers released from agriculture in a less developed country will need training before they can become productive members of the industrial workforce.
The market may not deliver the training that is necessary, as firms will not invest in training workers unless they can be sure that they will not be poached by competitors once they have completed their training. The government may therefore need to provide incentives. One particular concern has been the number of young people aged between 16 and 18 who are not in education, employment or training (known as NEETs). At the end of 2016 it was estimated that 6% of 16-18-year-olds were in this category. The Department for Education has piloted a number of initiatives to tackle this problem.
This sort of intervention by government can improve the flexibility of the labour market, by enabling workers to move more readily between jobs - or even occupations. Education and training also have a direct impact on the productivity of workers, which can improve productive efficiency. Again, the impact of such measures is to result in a rightward shift in the long-run aggregate supply curve.
How is infrastructure an interventionist policy?
An important area of government expenditure relates to the provision of infrastructure. Firms need there to be efficient transport and communication networks, and other types of infrastructure that enable markets to operate effectively. The public goods aspects of infrastructure mean that the free market mechanism will not adequately provide for them, so government intervention is needed. The objective of investing in infrastructure is to improve future productive efficiency, which again should have the effect of shifting long- run aggregate supply to the right. However, a word of caution is needed. Government undertakes expenditure for a wide variety of reasons. This means that it is important to set priorities in the allocation of funds.
How is subsidies an interventionist policy?
One of the hindrances to structural change in the economy has been that declining sectors of activity have not always been located in the same regions as the expanding sectors, making it difficult for displaced workers to gain employment in the newly growing industries. In England, this led to a North-South divide, with industries in the North in decline, and the growth areas being in the South.
This phenomenon is not unique to the UK economy, and across Europe there are substantial differences in unemployment rates. One way in which this can be tackled is through the use of subsidies. For example, firms that agree to set up their operations in disadvantaged regions could be offered incentives in the form of investment subsidies. The UK has operated such subsidies in the past, and the European Commission has also provided assistance to regions with high unemployment rates. Indeed, regions such as Wales in the UK benefited from such subsidies.
By giving subsidies in this way, the hope is to influence aggregate supply. However, it must be remembered that funding for the subsidies need to be financed somehow, and the danger is that by providing subsidies to encourage investment in some areas, there will be less investment elsewhere.
Information gaps are a form of market failure. One area in which this may be a problem is in the labour market, where workers may not have adequate information about job opportunities in other regions of the economy. By providing information about job vacancies, the authorities may be able to encourage mobility of workers, therefore improving the way in which the labour market operates. Subsidies for key workers in regions where housing and transport costs are high may also be a useful interventionist strategy to encourage labour mobility.
How is research and development an interventionist policy?
As technology improves over time, production becomes potentially more efficient. One way of achieving technological progress is through research and development (R&D). In spite of its universities and research institutes, the UK has not devoted as much funding to R&D as some other advanced countries.
This may be an area in which the UK could do more, perhaps through direct government funding, or by tax relief on R&D expenditure. However, again it may be important to bear in mind the opportunity cost of supporting R&D relative to other areas of government spending
How is competition policy an interventionist policy?
A recurrent theme in many policy statements from governments and international organisations like the World Bank and the IMF has been the importance of promoting competition. There are several reasons why this might be important in influencing aggregate supply. One possibility is that a monopoly firm in a market may be able to use its market power to maximise profits by restricting output and raising price. If such a firm is forced to confront competition from other firms, it may have to temper its use of that market power, and reduce price in order to sell more output and protect its market share.
The intensity of competition may also affect firms’ willingness to improve productivity. It is possible that in some markets the lack of competition will produce complacency, depriving firms of the incentive to operate at maximum efficiency. Policies that promote competition may therefore lead to improvements in both allocative and productive efficiency. Competition policy aims to promote competition by monitoring the actions of firms in order to protect consumers from the abuse of monopoly powers.
How is immigration control an interventionist policy?
A highly contentious issue has been that of the control of immigration, which has aroused some emotional debate. In considering the topic, it is important to focus on the economic arguments.
The discussion of economic growth focused on factors that affect the position of the aggregate supply curve. It argued that an increase in capacity output can come either from an increase in the quantity of the factors of production, or from an improvement in their efficiency or productivity. A tightening of immigration control would mean that the workforce would be smaller than it otherwise may have been, suggesting that the aggregate supply curve would shift to the left.
Those who argue that the UK should accept fewer immigrants assume that migrant workers will become unemployed and be a burden to taxpayers, or that they will take the jobs of native workers, and thus increase the level of unemployment.
Translating this into economic terms, this reflects an assumption that migrant workers will be substitutes for native workers. If migrants have different skills than native workers, then the situation is rather different. If the migrants have higher productivity than native workers, there will be an increase in the demand for labour, and a resulting increase in both employment and the wage rate. Furthermore, the multiplier effect from the incomes of the migrant workers will mean that there is also an increase in the demand for unskilled workers, so there will be a positive impact on unskilled native workers. Indeed, if the migrant workers share their knowledge and skills with other native workers, their productivity will also increase.
What is the evaluation of supply side policies?
In general, the strengths of supply-side policies are that they are targeted on specific problems that can inhibit economic growth by limiting the productive capacity of the economy. Supply-side policies can be important in shifting aggregate supply and enabling an increase in the productive capacity of the economy. However, it is also important to remember that these are policies for the long term, and many of them take time to become effective. For each of the policies discussed, there may be problems in identifying the magnitude of the effects that can be anticipated.
A weakness is the need for careful balancing of the effects of some policies. For example, lowering unemployment benefits to encourage more people into work may cause suffering for those unable to work, unless the policy is carefully designed.
What is evaluation of privatisation and deregulation as a market based policy?
Privatisation is said to improve efficiency mainly because managers of state-owned businesses are not held accountable for their actions, so that inefficiency can set in. If such enterprises are privatised, it is argued that managers will be more accountable to their shareholders, and may therefore become more efficient. However, will this happen in practice? With separation of control from ownership with multiple shareholders, the principal-agent problem may emerge, such that managers may still find themselves able to pursue their own objectives.
In some cases, privatisation has failed to deliver. For example, in 2018 the franchise to run the East Coast main railway line was terminated and train operations were brought into public ownership.
Deregulation is said to improve efficiency by freeing firms from unnecessary restrictions on their behaviour. Whether this will be the case depends upon the nature of the regulation that was in place, and on whether it was excessive. Critics might argue that freedom from regulation gives a firm the freedom to exert its market power, which would not necessarily lead to an increase in aggregate supply.
What is evaluation of improving labour market flexibility as a market based policy?
The key argument in favour of improving the flexibility of labour markets is that it allows the economy to respond more rapidly to changes in global demand conditions. This enables aggregate supply to increase because firms are better able to provide the goods and services that people at home and abroad want to buy. For example, if the power of trade unions is limited, workers may be more free to accept jobs that are available, and employers will be able to offer jobs at the equilibrium wage rather than having the level of employment restricted by union rules. This may indeed have a positive impact on aggregate supply, which would be seen as favourable, as long as employers do not abuse their new freedom.
There is also an important question to consider, which is whether market forces will be sufficient to ensure flexibility without some additional measures. For example, it might be argued that some interventionist policies may also be required to ensure full flexibility, perhaps by provision of the education and training needed for workers to be ready for new jobs and occupations.
What is evaluation of reforming taxes and benefits as a market based policy?
This aspect of policy is aimed at improving incentives, by making sure that high tax rates for the well-paid do not discourage the supply of effort, and by making sure that the levels of benefits are not set so high that workers will not accept low-paid jobs.
The success of this approach depends crucially on getting an appropriate balance. At the top end of the income distribution, the question is one of maintaining incentives to work while still enabling a fair redistribution of income from rich to poor. In terms of benefits, the issue is balancing the need to protect the vulnerable against encouraging individuals to accept jobs and therefore contribute to aggregate supply.
What is evaluation of interventionist policies?
There are two key issues when it comes to evaluating interventionist measures. One is the awareness that in most cases, such policies are effective only in the long term. For example, influencing aggregate supply through improving the education system is a long-run policy, and even the provision of retraining for displaced workers may not be achievable in the short run. However, this is a crucial part of supply-side policy, which complements the market-based approach and enhances the flexibility of labour markets. The need for such intervention is to correct for the market failure that is present. The improvement of infrastructure is another policy that may only have long-term effects. However, this is also necessary because of the need to deal with market failure.
The second key issue is the question of opportunity cost that was mentioned earlier. Balance is also needed here, providing appropriate investment for the future, but maintaining essential services for the present generation.
In the case of R&D expenditure, there is an additional complication. Competition policy may be used to prevent firms from gaining market dominance and being able to make high profits, but it may be that only large firms can make enough profit to be able to undertake R&D. Again, there is the question of balance.
