Aims of supply-side policies

Government supply-side policies aim to affect aggregate supply and achieve the macroeconomic objectives of:

• Sustainable economic growth
• Low unemployment
• External balance of the current account balance of payments
• Low inflation or price stability

Supply-side policies and long-run economic growth

Long-term growth

Supply-side policies are often viewed as a long-term strategic set of policies to facilitate future economic growth over a period of time. For example, increasing the numbers in university education to improve the skill level of the labour force may take 10 to 20 years to have a significant effect on the growth of the economy.

Increasing productive capacity

To achieve long-term economic growth, supply-side policies are often targeted at improving the productive potential of the economy.  This means using policies that increase potential output, shifting the production possibility curve and long-run aggregate supply curve of an economy outwards. This is illustrated by diagram 3.43 where the long-run aggregate supply curve increases from LRAS to LRAS1. A government spending programme on significant improvements to infrastructure in the economy would be aimed at increasing productive capacity.

What are market-based supply-side policies?

The market-based approach

The market-based supply-side approach involves the government trying to increase aggregate supply by using policies that allow markets to function more efficiently and to achieve the macroeconomic objectives of sustained economic growth, price stability and low unemployment.  Through market-based supply-side policies, the government tries to create the market conditions needed to allow the private sector of the economy to find solutions to economic problems.

Market-based supply side can be looked at as three distinct policy approaches:

• Policies that encourage competition in markets. This is based on the assumption that more competition between businesses increases economic efficiency.
• Policies that try to increase efficiency in the labour market. This is particularly important for employment and worker productivity.
• Incentive-related policies to increase efficiency, investment and innovation.

Increasing potential output

The increase in investment and innovation brought about by market-based supply-side policies will cause the long-run aggregate supply curve to shift outwards from LRAS to LRAS1 in diagram 3.43. This can also be shown by a shift outwards in the production possibility curve from PPC to PPC1, which is shown in diagram 3.44.

Increasing actual output

The improvement in efficiency brought about by market-based supply-side policies can lead to an increase in actual output which is illustrated in diagram 3.45 by a shift from A to B as the economy moves closer to potential output.

A market-based approach to achieving long-run economic growth

Deregulation of markets

Over time, markets can become increasingly regulated to protect workers, the environment, health and safety and the consumer. For example, a clothing manufacturer might be required by law to pay a minimum wage, put in place health and safety systems on the production line and use sustainable materials when manufacturing its products. Even though the aims of these regulations might be to improve welfare they can add to business costs and reduce productive efficiency by making decision-making more complex. By reducing or removing regulations, business costs might fall and productive efficiency might increase.

Privatisation of industries

Many industries have been owned and controlled by the government. This is particularly true in utilities such as energy and water, but also transport and communications. In the UK, for example, British Gas, Royal Mail, British Telecom, British Rail and British Airways have all been state-run enterprises in the past. Over the last 30 years, all these industries have been privatised. This means the assets have been sold to private investors and they have employed management to run the businesses. The theory of privatisation is that private sector organisations run more efficiently than public sector enterprises, and this increases overall efficiency in the wider economy.

Trade liberalisation

Most economists believe that free international trade increases efficiency in an economy through increased competition and specialisation of resources. Many countries use trade barriers, such as tariffs and quotas, to protect certain markets. When trade is liberalised and trade barriers are reduced or removed, this increases free international trade and the efficiency gains that go with it.  The ASEAN free trade agreement, for example, between countries such as Indonesia, Malaysia, Singapore, Thailand etc, increases trade liberalisation and the efficiency gains that go with it.

Monopoly and competition regulation

When monopolies become established in markets they reduce competition and this leads to a fall in business efficiency. Section 2.11 of this book focuses on monopoly as a market failure and how the existence of monopolies reduces economic efficiency. As part of a market-based supply-side approach, the government puts in place laws and regulations that prevent monopolies from occurring or regulate monopolies if they do exist. The European Union, for example, has specific laws in its Single Market that prevent monopoly practices such as cartels occurring amongst member countries of the EU.

Reducing the power of trade unions

A trade union is where a group of employees join together to try to maintain and improve the wages and employment conditions of their members. Many economists who advocate a market-based supply-side approach believe that the power of trade unions should be reduced because they reduce business efficiency and prevent innovation and change. In 2019 many transport workers in France went on strike because of proposed changes to their working conditions. The French government were trying to push through market reforms that could reduce business costs and increase efficiency.

Changes in taxation

Changes to tax rates and the tax system are seen as an important way of creating greater incentives in the economy to increase efficiency, investment and innovation. Cutting taxes means that workers will keep a larger proportion of their income, which may increase their incentive to work harder and improve productivity. Reducing corporation tax on businesses means they can keep a higher proportion of their profits, which they can use to fund new investment and research and development. Lower tax on businesses may also encourage new firms to start up in the economy.

Evaluation of market-based supply-side policy to achieve economic growth

Strengths

• Market-based supply-side policies use the power of the market to achieve economic growth. The interaction of private business and consumers might be more powerful in affecting economic growth in the long run than interventionist supply-side policies.
• The market-based approach does not involve the government expenditure costs of the interventionist approach.
• Similar to interventionist supply-side policies, the market-based approach does not cause inflation in the same way as expansionary demand-side policies do.

Weaknesses

• A market-based approach can work in the long run, but it is relatively ineffective compared to expansionary demand-side policies in achieving an increase in the current rate of economic growth. The market-based approach will not be as effective in a recession when a government needs to respond quickly to a fall in economic growth.
• If the deregulation aspect of the market-based approach involves reducing environmental laws, it can have a negative effect on the environment.
• The market-based approach can have a negative impact on low-income workers who may see their incomes and working conditions negatively affected if the government decides to decrease minimum wages and cut back on employment protection.
• If the market-based policy involves reducing income and corporation tax, this could widen income inequality in the country.
• Trade liberalisation involves a country reducing trade barriers, which leads to some industries being exposed to low-cost foreign competition which could cause business failure and unemployment.
• Privatisation of certain industries may lead to private sector monopolies which may cause prices to rise. In the energy and public transport markets, this can have a particularly negative impact on the consumer.

Market-based supply-side approach to unemployment

Direct tax and benefits

Reducing direct taxation creates a greater incentive for workers to take available jobs which can reduce the amount of unemployment. If governments reduce unemployment benefits this also increases the incentive for workers to accept jobs.  A combination of lower direct tax and reduced benefits makes the opportunity cost of not accepting a job higher because the difference between someone’s income in work increases relative to the transfer payments they might receive if they are out of work.  

Trade unions

Yellow-vest union protests to labour market reforms in France

Reducing the power of trade unions takes away some of the impediments that prevent firms from hiring new workers.  This is particularly true where trade unions negotiate wages above their market equilibrium level and cause the quantity demanded of labour to fall.

Minimum wages

Minimum wages can cause a disequilibrium in the labour market, which means the quantity demanded for labour is less than the quantity supplied of labour. If a government reduces the minimum wage in the economy, the quantity demanded for labour rises and there is a decrease in unemployment. Reducing minimum wages is often seen as important to small businesses and this can encourage them to hire more workers.

Labour market regulations

Governments can reduce the amount of labour market regulation that prevents firms from taking on new employees.  If there are over-protective regulations, such as statutory redundancy payments, then firms are less likely to take on workers because of the high cost of making workers redundant.

Evaluation of market-based supply-side policy to reduce unemployment

Strengths

• Market-based supply-side policies can make the labour market more dynamic and reactive to change. For example, reducing regulations can make it easier for firms to take on workers more quickly when they are expanding.
• There is evidence that the private sector is better at creating jobs than the public sector.
• The increased incentives associated with market-based supply-side policies can increase worker productivity.

Weaknesses

• Market-based supply-side policies can have harsh effects on the unemployed.  If unemployed people cannot find jobs in a recession, then cutting their benefits will lead to increased poverty.
• Decreasing employment regulation can reduce the protection workers have in their jobs, which in turn leads to greater job insecurity and can cause the exploitation of workers.
• Reducing direct tax might mean unscrupulous employers reduce pay rates because they know workers are going to receive a rise in their disposable income.
• Taking away minimum wages legislation means pay rates will fall in certain industries, which can lead to greater levels of poverty.

Market-based supplied policies to reduce inflation

Monopoly and competition regulation

Market-based supply-side policies that increase competition in the economy and reduce the power of monopolies can lead to increased efficiency and lower prices. This is illustrated in diagram 3.43 where the increase in long-run aggregate supply from LRAS to LRAS1 causes the average price level to fall and reduces the rate of inflation.

Reducing the power of trade unions

Trade union activity can push up wages in the economy, which increases business costs. This can lead to cost-push inflation. Market-based supply-side policies to reduce the power of trade unions mean that union activity is less likely to push up wage costs.

Changes in taxation

Reducing direct and indirect taxes can lead to lower business costs and increase business efficiency, which leads to reduced inflationary pressures in the economy. For example, a reduction in VAT can directly reduce the average price level in the economy.

Privatisation of industries

The increased efficiency privatising key industries can bring to the economy can lead to lower prices and reduced inflation. Privatisation of energy companies can be particularly significant because gas and electricity costs are a major part of consumer expenditure and business costs.

Deregulation of markets

Removing and reducing regulations on businesses can increase efficiency and reduce business costs, which creates the conditions for lower prices and reduced inflation.

Evaluation of market-based supply-side policy to reduce inflation

Strengths

• The market-based supply-side approach can reduce the average price level and inflation in the long run at the same time that national income increases. Contractionary demand-side policies reduce inflation, but often at the cost of falling national income.
• Increasing economic efficiency and competition in markets can create the conditions for price stability in the long run.

Weaknesses

• A market-based supply-side approach is a long-run approach to achieving price stability and often a rise in inflation requires an immediate policy response. Governments normally use contractionary fiscal and monetary policy to achieve this.
• Reducing inflation using a market-based approach can have negative consequences in terms of inequality, workers’ rights and increased foreign competition.