Supply-Side Policies

What Supply-Side Policies Do

Supply-side policies: policies that aim to increase an economy's productive capacity, shifting long-run aggregate supply (LRAS) to the right.

Demand-side policies change how much is spent. Supply-side policies change how much the economy can produce, by raising the quantity or productivity of labour and capital. Many also cut firms' costs, which shifts short-run aggregate supply (SRAS) right as well.

Market-Based and Interventionist Methods

Market-based policies: supply-side policies that reduce the government's role, so markets work more freely and incentives are stronger.

Interventionist policies: supply-side policies in which the government spends, provides or directs resources to raise productive capacity.

Market-based policies, such as tax cuts and deregulation, rely on firms and workers responding to incentives. Interventionist policies, such as spending on training or roads, fill gaps the market leaves because firms would provide too little of them.

Policies for Each Aim

Each aim raises capacity in a different way:

• Incentives: lower tax on income → work pays more → more people join the labour force or work longer hours → more labour, so higher output.
• Competition: lower barriers → new firms enter → existing firms must cut costs and innovate → lower prices and higher productivity.
• Labour market: wages and hiring respond more easily to demand → firms take on staff more readily → lower unemployment.
• Skills: better training → workers produce more per hour → firms' unit costs fall and workers can earn higher wages.
• Infrastructure: faster transport and broadband → lower costs of moving goods and people → firms can reach more customers and invest where they could not before.

Showing Supply-Side Policies on a Diagram

A successful supply-side policy shifts LRAS to the right. Real GDP rises and, with AD unchanged, the price level falls. On the classical diagram, full capacity output itself moves, from Yfe1 to Yfe2.

On the Keynesian diagram the whole curve moves right, so the economy reaches full capacity at a higher output.

Strengths and Weaknesses

When supply-side policies work:

• Growth without inflation: capacity rises → output can grow without firms running short of workers and materials → less pressure on costs and prices.
• Lower unemployment: better skills and job matching → people fit the vacancies on offer → structural unemployment falls, which demand-side policy cannot fix.
• Exporters: higher productivity → lower unit costs → UK goods compete better on price abroad → more export sales.
• The government: a larger, faster-growing economy → more tax revenue and fewer benefit claims → the budget deficit narrows over time.

Their weaknesses:

• Time lags: a new apprentice takes years to become fully skilled, and a rail line can take a decade or more to build.
• Cost: interventionist policies need government spending, with an opportunity cost in other services or higher borrowing.
• Uncertain results: an income tax cut may lead some people to work fewer hours for the same pay, and a firm may keep a tax cut as profit.
• No help in a recession: extra capacity is wasted if demand is weak and firms cannot sell what they already make.

How well they work depends on:

• The type of policy: market-based policies are often cheaper for the government; interventionist ones can reach problems markets ignore, such as training for workers who might leave for a rival firm.
• The cause of the problem: they help most where low output comes from a skills gap, poor transport or weak competition.
• How well they are run: money spent on the wrong projects, or deregulation that lets firms cut safety corners, is government failure.

Policy Conflicts and Trade-Offs

• Efficiency or equality: cuts to top tax rates, benefits and union power → stronger incentives → but the gains go mainly to higher earners and the low-paid can lose out.
• The budget now or growth later: spending on education and infrastructure → higher borrowing today → with the growth, if it comes, years away.
• Growth or the environment: new roads, runways and faster planning → more output → but more emissions and lost green space.
• Workers or firms: flexible contracts → firms hire more cheaply → but workers face less job security and less predictable pay.