Supply Side Policies

Supply Side Policies

Supply side policies are those that improve the supply side of the economy. In other words, they are government policies that increase the amount of 'supply' that is capable of being produced over the long term. They improve the productive potential of the economy. Diagrammatically, it can be illustrated by an outward shift in the production possibility frontier (PPF), or a shift to the right of the long run aggregate supply curve (LRAS curve). In the next two sub-sections you will see that Keynesian and Monetarist (and classical) economists disagree about the need for these policies. First we shall look at some examples of these policies. They can be split into those to do with the product market and those linked to the labour market.

Product market supply side policies

All of the policies in the product market are designed to increase competition, and so efficiency. If the productivity of an industry improves, then it will be able to produce more with a given amount of resources, shifting the LRAS curve to the right. All of the following policies are, in some way or another, trying to increase the level of competition in product markets.

  1. Privatisation. This was the major supply side policy on the product market side of the 1980s. The privatisation of various large industries (telecommunications, electricity, gas, etc.) was designed to break up the state monopolies to create more competition. Of course, many of these privatisations simply turned public sector monopolies into private sector monopolies, but there have been efforts to introduce competition into these industries. You may have seen the numerous TV adverts by lots of companies selling gas and electricity. Some large companies were also privatised, so that they would be exposed to the rigours of the market. British Airways is an example. For more details on the topic of privatisation, see the topic with the same name.
  2. Deregulation. This is another form of privatisation. The best example is the deregulation of the bus industry. Competition was certainly increased, but many questioned whether the quality of services remained the same. Some economists would include the deregulation of the capital markets (1979) and the stock exchange (1986) in this section.
  3. Membership of the WTO. This may not seem like a 'policy' as such, but it does symbolise a country's commitment to 'free trade'. If you look at the topic called 'Why trade', you will see that trade between countries, whose different resources mean that they are good at making different goods, is beneficial to all concerned. World real output is higher than it would otherwise be when tariffs are removed and trade is free.
  4. Help for businesses. In particular, small businesses. The governments of the 80s encouraged enterprise with various grants, reductions in small business tax rates and tax breaks for investment. The new Labour government has also helped with training for those thinking of starting a business and guarantees on bank loans for those that would have had no chance of getting a bank loan otherwise.

Labour market supply side policies

The following policies are all designed to improve the quality and quantity of labour. Increased numbers will obviously increase the productive potential of an economy. Increased quality will improve the productivity of labour. If a given amount of labour increases its productivity, then they will produce more with a given set of resources, and so the productive potential of the economy will again improve. As with the product market policies, successful labour market supply side policies will shift the LRAS curve to the right.

  1. Legislation against trade unions. Trade unions are a barrier to the free working of a labour market. They stop employers from negotiating the wage individually with employees and arriving at the equilibrium wage. Unions tend to push the wage above the market equilibrium, and, in the 70s especially, can be quite disruptive in terms of going on strike. The governments of the 80s passed many laws in Parliament to reduce the power of the trade unions. This made labour markets more flexible and efficient. See the topic called 'Labour markets' for details.
  2. Education and training. Some would say that this is the most important of all supply side policies (Blair - "education, education, education"). Government spending on education and training improves workers' human capital. They become better quality workers. Their productivity improves and so the LRAS curve shifts to the right. Economies that have invested heavily in education are those that are well set for the future. Most economists agree, with the move away from industries that required manual skills to those that need mental skills, that investment in education, and the retraining of previously manual workers, is absolutely vital. It should also be noted that improved training, especially for those who lose their job in an old industry, will improve the occupational mobility of workers in the economy.
  3. Income tax rates. Whilst income tax is a requirement, so that the government can pay for important public services, there is always someone who thinks that it is too high! In the late 70s, very few would have disagreed. The highest marginal income tax rate was over 80%! Even the basic rate, paid by relatively low earners, was 33%. This meant that is you were a relatively high earner, you would pay more than 80p in every extra £1 that you earned. Unsurprisingly, many felt that this was a disincentive to work in the labour market. Why work harder if the government will keep most of your earnings? The governments of the 80s reduced these high marginal income tax rates to encourage more people to work hard. The final big drop was in the Budget of 1988, when the top marginal rate fell from 60% to 40% where it remains today. Of course, indirect taxes were raised to make up for it (e.g VAT), but the point was to get more people to be economically active, and those already in work might work harder.
  4. Unemployment benefits. In some countries where government spending is relatively high (like Sweden and France), unemployment benefits are so high that the difference between disposable income in work and benefits received out of work is small. There is little incentive to take a job. If the unemployment benefits are very low, so low that it is difficult to live on benefit alone, then even low paid jobs will seem attractive. Some very extreme supply side economists believe that unemployment benefit should not exist! The other option is to offer in-work benefits. The new Working Families Tax Credit is a benefit that is paid through the pay packet. Whether out of work benefits are reduced or in work benefits are increased, the idea is to create incentives for people to work and so increase the supply of labour and the productive potential of the economy.

Supply side policies are very popular with classical, or monetarist, economists. The following diagrams should explain why.

Look at the diagram below.

Why monetarists like supply side policies

You can see a 'normal' looking AD curve and the initial LRAS curve, LRAS1. This gives an equilibrium level of real national income of Y1 at a price level of P1. It is clear to see that, given the assumption of the classical economists that the LRAS curve is vertical at all price levels, and shift to the right of this curve due to supply side policies will be beneficial both in terms of a higher level of real national income (Y2) and a lower price level (P2).

The monetarist governments of the 80s were very keen on supply side policies. Many of these policies were long term in nature. Some economists think that the Labour government should thank the Conservative governments of the 80s for creating the right economic fundamentals for healthy, but sustainable, growth to occur in the late 90s and beyond.

As we shall see in the next section, these policies did not work in the depression of the 30s when there was a severe lack of demand.

Keynesian economists agree that the productive potential of the economy can be improved with supply side policies, but stress that this is of no use if there is a depression, or a severe recession, where a chronic lack of demand is the key problem.

The Keynesian view

As a result of supply side policies, the LRAS curve has shifted to the right, but only the vertical part has shifted. This is still a good thing because the productive potential of the economy has improved. A higher real national income can be achieved before the cost of a rising price level kicks in.

But these policies are no good in times of severe recession, or depression. If an economy is currently at a level of demand represented by AD1 (price P1, real output Y1), the increase in the possible full employment level of real output from YFE1 to YFE2 is of no significance. The price level and real income level both stay the same. This is also true for the level of demand represented by AD2. If the economy has a level of demand represented by AD3, or even AD4, then the supply side polices will be useful (similar to the classical diagram above), and Keynesians would admit this fact, but in times of depression, they argue, supply side policies are of no use. In fact, they could make things worse. Reducing unemployment benefit at a time when unemployed workers simply cannot get a job due to the lack of demand in the economy will make their plight even worse. Also, they themselves will have less money to spend, thus accentuating the problem of lack of demand.