Supply side policies aim to either increase the quality/quantity of factors of production or to improve market efficiency, increasing the productive potential of the economy.
A) Distinction between market-based and interventionist methods
Interventionist methods occur when the government actively gets involved in the market in ways such as, increasing government spending on education or reducing taxation in order to encourage investment. On the other hand, market-based methods try to keep the government out of the economy, allowing markets to act freely.
B) Market-based and interventionist policies:
To increase incentives
A good example of this is a reduction in income tax. By doing so it encourages more people to enter the workforce. This is because they will get to keep more of their income, meaning if they do work, they’ll get more disposable income. As there are now more workers available, more goods/services can be produced, causing LRAS to increase. In addition to this, the reduction in income may also incentivise those currently working, to work harder.
Another example is a reduction in corporation tax. This allows firms to keep more of their profits, incentivising them to spend that profit on investment. An increase in investment would increase the quantity/quality of factors of production.
To promote competition
Privatisation can increase efficiencies through increased competition. By letting the free market provide certain goods/services it allows for efficient market outcomes as a result of the profit motive. Unlike the government, private firms can make a profit and therefore it is in their best interest to reduce costs and work as efficiently as possible so that they are able to compete against other firms. The increase in market efficiency causes LRAS to increase.
In addition to this, deregulation also increases competition as it encourages more firms to enter the market. In order for existing firms to compete with new entrants, they must become more efficient. This causes an increase in market efficiency.
To reform the labour market
Policies could be introduced in order to tackle the geographical immobility of labour, such as improving information on job vacancies and subsidising worker relocation. This improves labour market flexibility as it reduces the problem of labour shortages in certain areas and labour surpluses in other areas.
The benefits system can be reformed to encourage workers to take available jobs. For example, welfare benefits could be reduced, increasing the incentive for people to take the jobs available to them as it would result in a bigger increase in disposable income than before.
Minimum wages and trade unions can cause wages in the labour market to be fixed above the equilibrium wage rate. This causes an excess in the supply of labour meaning that the labour market is not working at equilibrium, resulting in inefficiencies. By reducing or abolishing the national minimum wage and trade union power, it allows wages to fall to the equilibrium wage rate, thus increasing the efficiency of the labour market.
To improve skills and quality of the labour force
This can be achieved through a number of ways, the main one being increased government spending on education. The impact of this will be an increase in the quality of labour. A higher quality workforce will be more productive. Therefore, the productive capacity of the economy will increase as the potential amount of goods/services that can be produced within the economy using existing factors of production sustainably has increase, shifting LRAS to the right.
To improve infrastructure
Increased government spending on infrastructure such as roads and railway services increases productivity and efficiency as less time is wasted through excessive travel times. This will cause LRAS to the right. It can also help to reduce market failures such as, excessive pollution or congestion.
C) Use of AD/AS diagrams to illustrate supply-side policies
Supply side policies increase the productive capacity of the economy (Y1 to YFE) as the maximum amount of goods/services that can be made using existing factors of production sustainably increases. This causes a fall in the general price level (P1 to P2) as there is less pressure on existing factors of production. For example, at Y1 the economy was operating at full capacity, however, the increase in LRAS moved the economy to an equilibrium that is now less than the new full employment rate of the economy (YFE). This spare capacity can be shown by the difference between YFE and Y2.
Supply side policies can also be shown on a classical aggregate demand and supply curve. Supply side polices cause an increase in long run aggregate supply (LRAS1 to LRAS2). This causes an increase in real GDP (Y1 to Y2) and a reduction in the price level (P1 to P2).
D) Strengths and weaknesses of supply-side policies
Interventionist supply side policies such as investment in infrastructure can be extremely expensive for the government to finance.