Supply-Side Policies

EdExcel AS Economics 2.6.2

Supply-Side Economic Policies

They are policies that improve productive potential / capacity of an economy. Illustrated by an outward shift of LRAS (or of the PPF)

• Supply-side policies focus on improving the structural long-term performance of an economy

• There are different approaches to supply-side reforms• Market-led policies – designed to make markets work better

and give the private sector more freedom• State / government intervention in markets to overcome

different types of market failure• Supply-side reforms can affect both short-run and long-run

aggregate supply – but the focus is usually on LRAS• Time lags involved with supply-side reforms can be long

Key Supply-Side Challenges for the UK Economy

Persistent Productivity Gap

High rates of youth unemployment

Deep and widening regional economic

divide

Structural trade deficit (current account of BoP)

Low trend growth rate of real GDP

Rise of Emerging Nations

Low capital investment &

research

Rising inequality / relative poverty

Main Objectives of Supply-Side Policies

1. Improve incentives to look for work and invest in people’s skills

2. Increase labour and capital productivity

3. Increase occupational and geographical mobility of labour to help reduce the rate of unemployment

4. Increase investment and research and development spending

5. Promoting more competition and stimulate a faster pace of invention and innovation to improve competitiveness

6. Provide a strong platform for sustained non-inflationary growth

7. Encourage the start-up and expansion of new businesses / enterprises especially those with export potential

8. Improve the trend rate of growth of real GDP

Key concepts to focus on when discussing S-SPs are incentives, enterprise, technology, mobility, flexibility and efficiency

Difference between Production & Productivity

There is a clear distinction between production and productivity

• Production• Value of output of goods and services e.g. measured by

GDP or an index of production in specific industry• Productivity• A measure of the efficiency of factors of production• Measured by output per person employed• Or output per person hour

• An increase in production DOES NOT automatically mean an increase in productivity - it depends on how many factors of production have been utilised to supply the extra output

Evidence for the UK Productivity Gap

The table below measures an index of constant price GDP per hour worked for a range of countries – evidence of the productivity gap

France Germany Italy Japan UK USA

2007 100.0 100.0 100.0 100.0 100.0 100.0

2008 99.3 99.6 98.9 100.0 99.5 100.5

2009 98.7 96.9 96.7 99.1 97.8 102.9

2010 100.2 98.5 99.0 102.8 99.3 105.5

2011 101.4 99.5 99.1 102.8 101.7 106.0

2012 102.1 99.9 98.3 103.9 99.7 106.3

2013 102.4 99.4 98.5 105.5 99.4 107.6

Source: ONS, Feb 2015

Why does the UK economy lag on productivity?

Low rate of new capital investment in the UK

Banking crisis affecting lending to businesses

Possible slowing rates of innovation

Persistent skills shortages in key

industries

Relatively low levels of market competition

Low aggregate demand & high spare capacity

Economic Advantages of Higher Productivity

1. Lower unit costs: Cost savings for businesses can bring lower prices, encouraging higher demand, more output and an increase in employment

2. Improved competitiveness and trade performance (BoP)

3. Higher profits: Efficiency gains are a source of larger profits for companies which might be re-invested

4. Higher wages: Businesses can afford higher wages when their workers are more efficient

5. Economic growth: If an economy can raise productivity then the trend growth of national output can pick up

6. Productivity improvements mean that labour can be released from one industry and be made available for another

If Supply Side Policies Work

1. Achieve a sustained improvement in the possible trade-off between inflation and unemployment (see Phillips Curve)

2. Be more flexible in response to external demand and supply-side shocks such as rising energy prices

3. Raise living standards through stronger long term economic growth / an increase in underlying trend rate of growth

4. Reduce unemployment by lowering the natural rate of unemployment (less frictional & structural unemployment)

5. Improve competitiveness in global markets and achieve a stronger balance of trade in goods and services

In general, a stronger supply-side performance allows a government to meet more of the key macro objectives

Showing Long Run Economic Growth using AD-AS

General Price Level

Real GDP

GPL1

AS1

Y1

AD1

Yp1

LAS1

An increase in a country’s

productive potential causes an

outward shift of LAS. Short run

supply increases because of lower

unit costsAn increase in

productive potential allows an economy

to operate at a higher level of AD

LAS2

AS2

AD2

Yp2Y2

Pro-Market (Private Sector) Supply-Side Policies

These policies focus on reducing the size of the state and in boosting the role of market forces in allocating scarce resources

• Cutting government spending (including welfare) and borrowing• Lower business taxes to stimulate capital investment• Lower income taxes to improve work incentives• Reducing red-tape to cut the costs of doing business• Improving the flexibility of the labour market including reforming

employment laws and encouraging more part time work• Competition policies such as deregulation & anti-cartel laws• Privatisation of state assets – transferred to the private sector• Opening up an economy to overseas trade and investment• Opening up an economy to inward skilled labour migration

Recent UK Government Supply-Side Policies

Privatisation of Royal Mail

Patent Box Incentive

Modern Apprenticeships – e.g. the Youth

Contract

Welfare Caps / and other

Welfare Benefit Reforms

Shale Gas Tax Cut Incentives

Large Fall in Corporation Tax

UK National Infrastructure Plan including

HS2

Launch of a Green

Investment Bank

Government Intervention - Supply-Side Policies

Supporters argue that an interventionist state can have a powerful positive long-term effect on supply-side performance

• State investment in public services and critical infrastructure• A commitment to a minimum wage and/or living wage to improve

work incentives & productivity in the labour market

• Higher taxes on the wealthy to fund public and merit goods• An active regional policy to inject extra demand into under-performing

areas / regions of persistently high unemployment / low per capita income – e.g. the Government’s Northern Powerhouse Project

• Selective import controls to allow domestic industries to expand

• Management of the exchange rate to improve competitiveness

• Nationalisation of and/or stronger regulation of key industries

Regional Policy – The Northern Powerhouse Project

The UK government wants to achieve a greater degree of regional balance in the economy to help supply-side potential growth

• Goal of Northern Powerhouse idea is to have a balanced regional recovery

• North has a relatively higher concentration of public sector and manufacturing jobs and has grown less quickly since the end of the last recession

• Aim is to increase long-term growth in the major cities of the North including Liverpool, Manchester, Leeds and Hull

• Policy options include:

• Investment to improve transport connections

• Supporting science and innovation including the universities

• Backing specialist clusters of businesses including high tech sectors such as life sciences and marine engineering

Research and Development (R&D)

R&D is focussed on the creation and improvement of products and processes, based on scientific research – applied to market needs

• Spending on R&D in the UK has been <2% of GDP for many years

• The biggest barriers to innovation are

• Risk aversion – research is expensive, rewards are uncertain

• Uncertainty about ability to exploit research and make a profit

• A lack of high-skilled workers

• Top EU companies: Nokia, Volkswagen, Bosch and Siemens

• The top UK firms are GlaxoSmithKline and AstraZeneca

• The level of research spending is not necessarily a guide to the pace and success of innovation. Many businesses do not patent all their most innovative ideas but keep them as trade secrets

What is Innovation?

Innovation is putting a new idea or approach into action. Innovation is 'the commercially successful exploitation of ideas'

• Product innovation• Small-scale, frequent subtle

changes to the characteristics and performance of a good or a service

• Process innovation• Changes to the way in which

production takes place or is organised

• Innovation has demand and supply-side effects in markets and the economy as a whole

Austrian economist Joseph Schumpeter coined the term creative destruction.

This is a term that refers to the complete upheaval of the established order in the pursuit of innovation.

International (External) Competitiveness

External competitiveness is the ability to sell goods and services at competitive prices in a foreign country

• Cost competitiveness – differences in unit costs between producers – reflected in prices

• Non-price competitiveness – product quality, design, reliability and performance, choice, after-sales services, marketing, branding and the availability and cost of replacement parts

• Non-wage costs:• Costs of meeting environmental / health regulations• Environmental taxes e.g. carbon taxes and waste taxes• Employment protection laws and health and safety laws• Requirements to provide pensions for employees

Policies to Improve International Competitiveness

Improving functioning of Labour Markets• Investment in all levels of education and training• Encouraging inward migration of skilled workers • Improvements in management quality

Infrastructure Investment• Better motorways, ports, hi-speed rail• Northern Powerhouse project • Communications e.g. super-fast broadband, 4G networks

Supporting Enterprise / Entrepreneurship• Improved access to business finance e.g. for start-ups• Incentives for business innovation and invention• Reductions in business red tape

Macroeconomic Stability• Maintaining low inflation / price stability• A sustainable and more competitive banking system • A competitive exchange rate v major trading partners

Evaluating the Impact of Supply-Side Policies

Supply-side policies can have a powerful effect on economic performance – but be aware of limitations and disadvantages

1. Supply-side policies have long time lags – especially when they are trying to achieve structural changes

2. The level of aggregate demand is also important in making business investment and innovation viable

3. Some supply-side policies (e.g. cutting higher-rate income taxes) might lead to greater inequalities of income & wealth

4. State intervention to “pick winners” in different industries may be ineffective – there are risks of government failure

5. Sustainability issues if policies aim to raise a country’s long term growth rate – leading to increased externalities such as pollution

6. Supply-side policies look to achieve relative improvements e.g. In productivity – but other countries will be making gains too

Supply-Side Policies

EdExcel AS Economics 2.6.2