Supply-side policy

What is supply-side policy?

Supply-side policies are designed to improve the performance of an economy through the use of:

Incentives to increase productivity, and:

Measures to increase competition in markets to improve efficiency.

What are supply-side improvements?

The supply-side of an economy can also be improved by the actions of firms acting in their own self-interest. For example, increasing staff training or using the latest technology will increase productivity and benefits firms in terms of efficiency and gaining a competitive advantage. Other firms in the same industry may then adopt the same strategy in order to compete. This in turn may drive forward improvements in productivity in that industry. This is referred to as market driven supply-side improvement rather than deliberate supply-side policy.

Features of supply-side policy

Supply-side policies can be used to influence both the microeconomy and the macroeconomy. In terms of macreconomic performance, supply-side policy became an important policy tool in the early 1980s when economists and policy makers began to question whether fiscal policy alone could achieve key macroeconomic objectives.

The acceptance of the use of supply-side policy coincides with the 'rise' of supply-side economics in the late 1970s, popularised by American economist Arthur Laffer.

In essence, supply-side economics provided a return to the 'classical' economic tradition of the late 18th and 19th centuries, in which the attempt to identify and understand the principles and 'laws' of production, specialisation, and efficiency became the central purpose of economic theory.

This contrasts with the Keynesian economics of the 20th century, which focuses on developing an understanding of the role of aggregate demand as the primary means of achieving macroeconomic objectives.

Today, supply-side policies include a range of measures designed to improve productivity and efficiency, including:

  1. removing rigidities in the labour market, such as reducing trade union powers
  2. reducing marginal tax rates to encourage work
  3. reducing the level of welfare benefits to reduce welfare dependency
  4. business start-up incentives
  5. incentives to use new technology
  6. promoting training and education to increase employability
  7. promoting a healthy work-force
  8. removing obstacles to competition, such as deregulating markets and privatising industries

The effects of supply-side policy

Increasing potential output

Supply-side policy attempts to increase an economy's capacity and potential output in the long run. This can be shown by an outward shift in an economy's production possibility curve (or frontier).

The long run AS curve

In terms of AD-AS analysis, graphically, effective supply-side policy will shift the long run aggregate supply curve to the right.

Long run aggregate supply

Effect on unemployment and employment

Employment is largely dependent on real output in an economy. While aggregate demand drives growth, the impact on output largely depends on how aggregate supply responds.

Supply-side policies may make short run aggregate supply more responsive (elastic) to an increase in aggregate demand, and effective supply-side policies can shift the long run aggregate supply curve to the right. Both of these will increase real output, and increase the demand for labour. This in turn may reduce the current level of unemployment - assuming there is slack in the economy.

Video on supply side policy

Effect on the natural rate of output

Effective supply-side policy can reduce current unemployment below the natural rate without creating inflationary pressure.

The NRU is the rate of unemployment when the total labour market is in equilibrium. The NRU is composed largely of frictional and some structural unemployment, some of which is voluntary. By reducing marginal income tax rates, and providing incentives to work, the NRU may fall - albeit not by a great deal. As the NRU (or the alternative version, NAIRU) is reduced, the LRAS shifts to the right (as shown above) and the long run Phillips curve shifts to the left, as indicated below.

Phillips curve and supply-side policy

Effect on inflationary pressure

With a more effective labour market and more competition in the economy, factors of production will be used more efficiently. This is likely to reduce upward pressures on prices, as can be shown diagrammatically.

Supply-side policy may increase productivity and reduce short run costs

Supply-side policy

Both the AD-AS diagram and the Phillips curve indicate that inflationary pressure is likely to be reduced following successful supply-side policy.

Effect on trade

Assuming improvements in productivity and efficiency (and downward pressure on prices) a country's exports are likely to become more competitive. At the same time, imports will appear less attractive, with the trade balance improving.

Unlike demand side policies, there appear to be fewer conflicts and it may be possible to achieve several objectives simultaneously.

Free-market vs interventionist supply-side policies

The above analysis is based on the 'free market' approach to improving supply-side performance - namely policies to encourage markets to solve the economic problem and allocate resources to where they are 'best' used.

Underlying this approach are three main economic schools of thought. Firstly, the approach of Laffer became highly influential after he argued that that a low tax strategy would provide strong incentives to workers and businesses. Secondly the 'crowding out' theorists also became influential when they argued that a large public sector would squeeze out a more efficient private sector. The third influential approach - at least in the 1980s - came from monetarists such as Milton Friedman, who attacked traditional fiscal policies in favour of a much simpler approach - all that a government or central bank had to do was control the money supply.

These approaches, and others, all pointed in one direction - namely that the size of the state (the public sector) should be restricted and that the role of government was very much 'hands off' to enable markets to work effectively.

However, interventionists, including the Keynesians see a positive role for the state in terms of improving the supply-side of the economy because they believe that markets are likely to fail both at the microeconomic and macroeconomic level, in terms of the provision of public and merit goods, and transfers to reduce poverty and inequality, and in terms of reducing the volatility of the economic cycle.

Interventionists are more likely to favour government financial support for education and healthcare, and for road building and transport infrastructure in general. Interventionists are also likely to favour state aid for struggling industries and direct support for agriculture and energy.

Criticisms

Specific 'free-market' supply-side policies have their critics, especially in terms of their potential effect on inequality - for example, measures to control trade union powers and to reduce welfare benefits are likely to impact most on the poorest and widen the gap between 'rich and poor'.  This is often referred to as the efficiency versus equity conflict - policies to improve efficiency may increase inequality and relative poverty.

Supporters of supply-side improvements point to the fact that supply-side policy improves employability and reduces unemployment - a major cause of poverty and inequality.

Also, critics argue that supply-side measures often take a very long time to have an effect, and because of that cannot deal with short term shocks, like the financial crisis and the COVID-19 pandemic. In the case of the pandemic, tax increases in the short run are inevitable to cover the cost of furlough schemes, losses in tax revenue, and increased public spending on healthcare.


Aggregate demand

Aggregate demand and the AD curve.

Aggregate demand
Fiscal policy

How can fiscal policy influence aggregate demand?

Fiscal policy
Monetary policy

How effective is monetary policy?

Monetary policy