Supply Side Policies Flashcards
What are supply-side policies?
A range of measures intended to increase long-run aggregate supply, so increases the productive capacity or potential of the economy.
These policies aim to increase the quality and/or quantity of different factors of production, as well as increasing the level of competition in different markets.
The different supply-side policies include:
Education and Training
Changes to benefits
Reducing ‘marginal’ rates of income tax
National Minimum Wage and the ‘living wage’
Improving labour market ‘flexibility’ and Trade Union Reform
Immigration
Privatisation and deregulation
Investment in infrastructure
Incentives to increase Research and Development
Subsidies to firms
Policy 1: Education and training
This is where investment in so called ‘human capital’ is encouraged.
This can be through a variety of different methods including:
Individuals remaining in full time education and training for longer periods of time.
‘In work’ training (workers are trained in new skills by their firms)
Specific government schemes such as: youth training schemes (aimed at providing young people with relevant skills to undertake a variety of jobs), apprenticeships, or retraining of workers.
The aim of increasing education and training is to improve the level of skills, if this is successful then workers’ productivity will rise (each worker will produce more in a given period of time and therefore overall Aggregate Supply in the economy will rise)
In addition, workers will become more flexible and occupationally mobile (workers will find it easier to move between different jobs because they have more skills)
Any rise in productivity levels will lower unit or average costs of production, therefore allowing firms to cut their prices and to become more internationally competitive, which may in turn raise export sales increasing AD and reducing unemployment.
Criticisms of Policy 1: Education and Training
- Any training and re-training scheme or greater spending on education will involve a considerable time lag before workers become available to the labour force (takes time and tends to be only effective in the long term)
- These policies can be really expensive, especially retraining. This means that the government will often incur a significant opportunity cost.
- In reality, an increase in spending on education and training does not guarantee an increase in the quality of education.
- The productive capacity of an economy will not increase ( and therefore neither will AS) if educated workers migrate to other countries.
- Workers must be re-trained with relevant and appropriate skills which are needed for them to find work in other areas.
However if the government increases spending on education and training, this has the potential to increase both AD (in the short-run as government spending is a component of AD) and also AS (in the long run). As a result, this could lead to sustained, non inflationary growth.
Policy 2: Changes to benefits
This is incredibly controversial. Nevertheless, the level of unemployment benefit paid to workers can be an important influence on labour supply (labour supply shows us the number of workers who are willing and able to supply/provide their labour services at each wage level).
This argue,ent suggests if unemployment benefits are set too high a level then workers will have less motivation to work and this will reduce levels of labour force participation (therefore increasing ‘voluntary’ unemployment). This is turn, will reduce the overall level of output produced from the nation’s factors of production and thereby reduce AS.
Therefore it’s suggested that if benefit payments are reduced the then the gap between the income received on benefits and the income received from working will widen. This will increase an individual’s incentive to work/accept a job at the given wage rate.
Overall, supporters of the policy believe that cutting unemployment benefits should lead to a rise in the labour supply by increasing individuals’ incentives to work, leading to a rise in Aggregate Supply.
Criticisms of Policy 2: Changes to benefits
- Unemployment benefits must not be set so low that they do not provide a ‘safety net’ for individuals to maintain a basic standard of living whilst they are unemployed. If benefits are cut too much then people may not be able to survive on these.
This policy could give rise to considerable concerns regarding income inequality and inequity. - Workers moving between jobs (‘frictionally unemployed’) will often rely upon benefits in the short term whilst searching for better jobs. If benefits are cut too much then it may well provide a disincentive to workers from looking for better jobs. In this way, this policy could actually reduce the flexibility of the labour market if workers are no longer willing to move between jobs.
Policy 3: Reducing ‘marginal rates’ of income tax (I.e. tax cuts)
The ‘marginal’ rate of income tax is the level of income tax which you will pay on the additional £1 of income which is earned.
In theory, if marginal rates of income tax are very high then this could discourage or disincentivise workers from working additional hours.
Therefore by cutting marginal rates of income tax, this should incentivise workers to work longer hours and therefore increase the overall number of hours worked in the economy, thereby increasing overall Aggregate Supply. This is called the ‘substitution effect’ - workers now substitute more labour in place of less leisure time.
This policy was very popular in the 1980’s with governments in the UK and US cutting income tax rates and shifting from direct to indirect taxes.
In addition, it is argued that as well as making existing workers want to work more hours, it also encourages more people to work generally. This may well be true of potential second inc9 e earners in a household who previously did not work, but following income tax cuts they may be more willing to work and supply their labour, hence increasing Aggregate Supply.
Criticisms of Policy 3: Reducing ‘marginal rates’ of income tax (I.e. tax cuts)
1.Even if such a policy is successful it is likely to be expensive. By cutting income tax rates the government is likely to lose tax revenues. It is not as simple as it appears - if the government cuts income tax this will incentivise some workers to work longer hours and may well actually end up paying more income tax if they work a great deal more hours! However, most economists would accept that a cut in income tax will reduce overall government tax revenues.
2. In some cases, a cut in income tax rates may actually result in a fall in the number of hours worked - hence reducing labour supply and AS! This might be the case in workers approaching retirement. They may realise that they could earn the same total earnings from working fewer hours. This is called the ‘income effect’ and suggests that workers are concerned about maintaining the same overall income and enjoy greater benefits from increasing the amount of leisure time which they can have. It all depends upon whether the ‘substitution’ or ‘income’ effect is greater.
3. Many workers do not have the power to change the number of hours they work, particularly in the short term. In the longer term there may be some flexibility in terms of the number of hours worked but for many workers this is not so in the short term. Hence this policy will not be effective in the short term.
4. Small cuts in income tax are likely to have much less impact on potential workers.
Policy 4: The National Minimum Wage and the ‘Living Wage’
A National Minimum Wage is the lowest amount of money which a worker can legally be paid. It is a ‘price floor’ below which wages cannot fall.
National minimum wage is set above the equilibrium wage.
In theory, the introduction of a National Minimum Age (or a rise in it) will increase workers’ incentive and motivation to find work. The recent rise in the UK minimum wage to £7.20 should raise the gap between the income received from benefits and the income received in work. This in turn should provide a greater incentive to people to move into employment, increasing the output of the economy… hence raising Aggregate Supply.
In addition, increases in the minimum wage may well also motivate workers who could become more productive… once again, increasing Aggregate Supply.
The benefit of setting a ‘living wage’ (a wage covering all basic costs of living) is that it may reduce government spending, supporting those on low incomes.
Overall, whether or not a Minimum Wage is a successful supply-side policy is determined by whether it encourages people to enter the labour market or not.
Criticisms of Policy 4: The National Minimum Wage and the ‘Living Wage’
- A national minimum wage, which is set too high, can lead to unemployment.
Firms can no longer afford higher wages and either cut the number of workers employed or reduce the number of hours that workers work. - Significant rises in a Minimum Wage can be a source of cost-push inflation.
Anything which adds to firms’ costs of production is likely to lead to reduced supply - hence lowering Aggregate Supply. - Other workers who are already paid more than the Minimum Wage may well want higher pay rises in order to maintain pay ‘differentials’. (In other words, the difference between wages paid to two different groups of workers). This would even further raise firms’ costs.
- Anything which raises firms’ costs of production, potentially increasing prices, is likely to reduce the price competitiveness.
Some people argue that the removal of a NMW is supply-side policy, because
It represents the removal of laws/regulations relating to the labour market.
Policy 5: Improving labour market flexibility & Trade Union reform
A more ‘flexible’ labour market may involve fewer government employment regulations and may also involve reducing the power of Trades Unions (as happened in the 1980’s).
Overall, the aim is to improve labour market flexibility and the ability of firms to respond to changing labour market conditions. Greater levels of labour market flexibility may also arise from policies designed to increase the mobility of labour (e.g. training and retraining to give workers more skills so that they can move between different jobs more easily, or improved advertising of job vacancies so that workers are aware of what existing jobs are on offer).
A major policy here is Trade Union reform:
Trade Unions are groups which represent workers and seek to protect and promote worker rights. The ultimate threat which a union has is to take strike action (i.e. the withdrawal of labour from the workplace). Strike action would clearly reduce output and labour productivity.
Others argue that if Trade Unions are successful in pushing up workers’ wages then this will raise firms’ costs of production leading to a leftwards shift of the Aggregate Supply curve.
In addition, some argue that Trade Unions create more inflexible labour markets by resisting the introduction of new working practices which, if introduced, could lead to increased productivity (and thereby increase AS).
If Trade Union power is limited and the number of strikes is reduced then output may be raised.
Criticisms of Policy 5: Improving labour market flexibility & Trade Union reform
- In some cases, Trade Unions may help labour markets work efficiently. By acting as a channel for communication between employers and workers on different issues, this may reduce firms’ costs of production (as it is cheaper to negotiate with one body rather than with individual workers). If this is true, then reducing Trade Union power may actually raise firms’ costs of production.
- Greater labour market flexibility and weaker Trade Unions may generally lead to some people having less job security with more workers on short term contracts.
In addition, Trade Unions represent workers and provide important support for workers.
Policy 6: Immigration
This could aim to increase both the number of workers in the economy generally but also the number of skilled workers in the economy (to fill any existing skills shortages which may exist). As such, by increasing the numbers of highly skilled workers this may successfully raise Aggregate Supply.
In theory we would expect increased immigration to increase the supply of labour.
Lower wages will reduce firms’ costs of production and, if repeated across the economy as a whole, should increase Aggregate Supply (remember that anything which lowers firms’ costs of production will result in an increase of supply).
In addition, with more workers in the economy then the total output of factors of production (and therefore the productive capacity of the economy) will rise increasing Aggregate Supply.
Criticisms of Policy 6: Immigration
1.Any increase in labour supply is likely to result in lower equilibrium market wages, however often labour markets are much more complicated than simple supply and demand suggests.
Policy 7: Privatisation and deregulation
Both of these policies are aimed at increasing the level of competition in different markets which should increase productivity and efficiency levels too.
Privatisation- This is where firms are moved from government ownership in the public sector into private ownership. (In practice, this often involves shares being sold to the public.
Deregulation - This is the removal of regulations (or laws) which acted as barriers to entry into markets. Then removal of such laws allows new potential private sector firms to enter the market and increase levels of competition.
By raising levels of competition, it is hoped that economic efficiency will be increased. (economic efficiency equals productive plus allocative efficiency).
Productive efficiency gains - To successfully compete in highly competitive markets, firms will have to sell their products at low prices. In order to cut their prices they will, first of all, have to lower their costs of production - hence being productively efficient.
Allocative efficiency gains - In competitive markets, firms will also have to produce exactly those goods and services which consumers want. By using scarce resources to produce exactly those goods and services demanded, firms will be allocatively efficient.
Overall, increasing levels of economic efficiency will raise the level of output produced from the same number of scarce resources - hence increasing the productive capacity of the economy and AS.
Criticisms of Policy 7: Privatisation and deregulation
1.Increased competition is not always guaranteed. After privatisation it is possible that there is limited or even no competition in markets. In the most extreme situation, a private sector monopoly may simply replace a public sector one which is arguably worse that a public sector / government run monopoly.
2. Whilst privatisation does generate the government significant revenues in the short term (with companies being sold to the private sector), if these industries are profitable then the government is forgoing a longer term stream of income from these industries.
