CH39 Supply-side policies

Question 1

what are supply-side policies?

Answer 1

supply-side policies are government policies designed to influence long run aggregate supply, or in other words, to increase the rate of economic growth
-they may also act specifically in certain markets to remove bottlenecks that prevent the economy from growing faster

Question 2

what is supply-side economics?

Answer 2

it is the study of how changes in long run aggregate supply will affect variables such as GDP

Question 3

what is meant by supply-side improvements?

Answer 3

changes in individual markets, such as investment by firms or improvements in the skills of workers which lead to an increase in LRAS without necessarily the intervention of gov

Question 4

where do supply-side improvements often originate in?

Answer 4

often originate in the private sector, independently of government

Question 5

what are bottlenecks?

Answer 5

these are supply-side constraints in a particular market in an economy which prevent higher growth for the whole economy

Question 6

how do supply-side policies mainly work?

Answer 6

supply-side policies mainly work through their impact on individual markets
-the policies are therefore aimed to improve the microeconomic performance of different individual markets. These, in turn, improve the macroeconomic performance of the economy

Question 7

what are the two types of supply-side policies?

Answer 7

market-based policies and interventionist policies

Question 8

what are market-based policies?

Answer 8

these are policies designed to remove barriers to the efficient working of free markets. These barriers limit output and raise prices.
-for example, in the labour market, they might reduce the willingness of workers to take jobs or to take risks. In the goods market, they might lead to inefficient production, high prices or a lack of innovation

Question 9

what are interventionist policies?

Answer 9

these are policies which are designed to correct market failure.
-this means the gov intervening in free markets to change the outcome from that which it would otherwise have been.
-e.g. free markets may underprovide education and so the government has to step in and provide education. Firms may be short-termist, only interested in maximising short run profits and failing to invest for the future. The gov might step in to encourage firms to invest

Question 10

what do economists disagree about the different types of supply-side policies?

Answer 10

economists disagree about whether market-based policies or interventionist policies are most effective.
-e.g. workers might be long-term unemployed. Is the problem that they are being paid too much in benefits to incentivise them to get a job? Or is the problem that they lack work skills needed to get them a job? Firms might spend too little on investment. Is the problem that they are taxed too highly on their profits? Or is it that they are subject to intense pressure from shareholders to deliver short-run profits at the expense of long-run growth?

Question 11

what do economists who support interventionist approaches argue is common?

Answer 11

economists who support interventionist approaches argue that market failure is common.
-free markets left to themselves, will create an inefficient allocation of resources leading to lower economic growth. Hence, the state needs to intervene to regulate markets and, where necessary, provide goods and services directly.

Question 12

what do proponents of market-based policies argue are vital for markets to function?

Answer 12

proponents of market-based policies argue that incentives are vital for markets to function effectively.
-if incentives are too small, or even worse, encourage the wrong economic decisions, then long run aggregate supply will suffer.

Question 13

what are the key variables which affect incentives to work and invest?

Answer 13

-taxes on income
-welfare benefits
-poverty and unemployment traps
-subsidising workers
-taxes on profits
-research and development

Question 14

how do taxes on income affect incentives to work and invest?

Answer 14

-in the UK there are 2 taxes on income: income tax and National Insurance contributions paid by employers, employees and self-employed.
-high taxes on income will discourage individuals from working. This could mean taking a job, or working extra hours or working hard at a job.
-high taxes for employers will discourage them from hiring workers. The key variable is not average tax rates, but marginal tax rates. If workers work an extra hour, how much will they be taxed on the earnings from that extra hour and how much will they take home after tax? If the marginal rate of income tax is 60percent, and a worker is paid £10 an hour, then £6 will go in tax and £4 will be left. If the marginal tax rate is 20percent, then £2 goes in tax and £8 will be left.

Question 15

what do free market economists believe about the elasticity of supply of labour? so what would happen if the marginal rate of tax was cut? However, what do other economists argue?

Answer 15

-they believe it is high.
-so cutting the marginal rate of tax from 20 percent to 15 percent will lead to a significant increase in the desire to work.
-however, other economists argue that small changes in marginal tax rates will have little effect on incentives. They point out that many workers are paid salaries and dont receive either overtime payments or bonuses. These workers cannot respond to changes in marginal tax rates expect in the long term by changing jobs or leaving the workforce.

Question 16

how do welfare benefits affect incentives to work and invest? what is one solution?

Answer 16

-incentives to work will be low if welfare benefits received by those not in work are too high in relation to the wages they could receive if they took a job. Hence, welfare benefits can reduce the level of AS because more workers remain unemployed.
-one solution is to cut state unemployment benefits to encourage workers to take on, typically, low-paid jobs. This can mean cutting rates of benefit paid to increase the ratio of pay to benefits. Or it could mean stopping benefits altogether if those out of work fail to seek work actively or take on jobs that are offered.

Question 17

how do poverty and unemployment traps affect incentives to work and invest?

Answer 17

-the combination of marginal rates of income tax and withdrawal of benefits can lead to poverty and unemployment traps.
-the poverty trap is a major disincentive for those working and receiving benefits to work harder or increase their skill. Reasons why is explained in another flash

Question 18

when does the poverty or earnings trap occur?

Answer 18

-the poverty or earnings trap occurs when a low income working individual or household earns more, e.g. by gaining promotion, getting a better paid job or working more hours, but the net gain is little or even negative. It occurs because as income increases, welfare benefits are withdrawn. Equally, the individual or household might start to pay tax.
-E.g. if an individual loses 50p in benefits when earning an extra £1, and then pays income tax and National Insurance contributions at 30percent, then the net gain from earning the extra £1 is only 20p (£1-50p-30p). The effective marginal rate of tax here is 80percent.
-If the benefit lost were 90p in the pound, the individual would be 20p worse off. The effective marginal rate of tax here would be 120percent.

Question 19

when does the unemployment trap occur?

Answer 19

-occurs when an individual is little better off or is even worse off getting a job than staying unemployed because of loss of benefits and taxation. The unemployment trap, where it occurs, is a major disincentive for the unemployed to find work

Question 20

what are solutions to both the poverty and unemployment trap?

Answer 20

-one solution to both kinds of traps is to lower welfare benefits but this increases poverty.
-the other solution is to reduce taxes on income and the rate of welfare benefit withdrawal as income increases. This is a more expensive solution for the gov and the taxpayer

Question 21

how does subsidising workers affect incentives to work and invest?

Answer 21

-one way to incentivise workers to take on work or work extra hours is to subsidise them for working.
-in the UK, low-paid workers can claim income tax credits. Instead of paying income tax, they receive tax rebates from the gov. These are designed to reduce the effective marginal tax rates that occur when low-paid workers pay tax and lose benefits. They help reduce the impact of the poverty trap

Question 22

how do taxes on profit affect the incentive to work and invest?

Answer 22

-in the UK, firms which are incorporated as companies have to pay a tax on their profits called corporation tax. Free market economists argue that high marginal rates of taxes on profits discourage firms from investing and from being successful. Tax taken from a company is not available to be reinvested in the firm to help it to survive and grow.
-high rates of tax also encourage firms to distribute profits to shareholders rather than invest for the future. This is because future profits after tax will be low and so the rate of return on investment made now will be lower than if taxes were lower.

Question 23

what affect does research and development have on the incentive to work and invest?

Answer 23

-spending on research and development can lead to technological progress when that research and development gives rise to more efficient ways of making, or creates new types of, goods and services.
-a market-based approach to increasing RandD spending would be to cut taxes on company profits or give gov subsidies to all types of RandD.
-an interventionist approach would be for the gov to undertake RandD itself, perhaps by giving funding to universities for research or by setting up its own research institutes. It could also give subsidies to firms but choose which RandD to subsidise.

Question 24

what are the 4 different supply-side policies which govs use to promote competition?

Answer 24

-privatisation
-deregulation
-competition policy
-industrial policy

Question 25

how does the supply-side policy of privatisation promote competition?

Answer 25

-privatisation is the sale of government organisations or assets to the private sector.
-over the past 50 years, the UK gov privatised many previously state-owned organisations, including airline companies, gas companies, prisons and hospitals.
-free market economists argue that gov-run organisations have little incentive to cut costs or innovate. There is therefore gov failure. Selling assets to the private sector enables those assets to be used more efficiently by private sector firms that are incentivised by the profit motive.
-critics would argue that private firms put profit before providing a good or service

Question 26

how does deregulation promote competition? what is a major problem with deregulation?

Answer 26

-deregulation is the process of removing government controls from markets. E.g. a local council might remove restrictions on the number of taxis for hire in their area. The gov might allow any bus company to offer services along a route. The gov might relax planning controls on the building of new houses. The aim is to encourage more firms to provide goods and services. This will increase output and lower prices.
-a major problem with deregulation is that is encourages ‘creaming’ of markets. This means firms only providing services in the most profitable areas of the market. E.g. in the postal market, Royal Mail is against deregulation because it argues that competitors will undercut the price it charges for providing postal services in urban areas, taking away revenue and profit that effectively subsidises postal services to rural areas

Question 27

how does competition policy promote competition?

Answer 27

-competition policy is designed to increase competition in markets, reducing the power of monopolies and making cartels and price fixing agreements illegal.
-by reducing prices and increasing output, competition policy should raise output in the economy and so increase AS

Question 28

how does industrial policy promote competition?

Answer 28

-industrial policy is gov policy to promote and support individual firms that it considers are important for the growth of the economy.
-it is an example of an interventionist policy.
-shipbuilding, mining, the motor manufacturing industry and steel were all examples of industries that received gov subsidies.
-free market economists would argue that govs are poorly placed to pick industry ‘winners’.
-UK industrial policy was more to do with managing the decline of these industries and firms than with promoting economic growth.
-however, countries such as Japan and South Korea have, arguably, in the past seen their govs successfully pick out firms that have contributed strongly to the growth of their economies.

Question 29

what is the level of long-run aggregate supply, in part, determined by?

Answer 29

by the quantity of labour supplied to the market and the productivity of that labour
-e.g. all other things being equal, an economy with 10million workers will produce less than an economy with 20million workers.

Question 30

what are the 4 supply-side policies which affect the labour market?

Answer 30

-improving labour market flexibility
-trade unions
-migration
-minimum wages

Question 31

how does improving labour market flexibility affect the labour market?

Answer 31

-labour flexibility is the degree to which demand and supply in a labour market respond to external changes and return to a new market equilibrium.
-more flexible labour markets, such as in the UK and the USA compared to many EU countries, are associated with lower unemployment and a higher participation rate with a larger proportion of the population working.
-however, they are also associated with lower average wages. There are more jobs, but those in work, on average are paid less.

Question 32

what are the 5 different types of flexibility?

Answer 32

-geographical flexibility: refers to the willingness of workers to move area to get a job, or the willingness of firms to relocate to take advantage of a more advantageous labour market
-external numerical flexibility: refers to the ability of firms to adjust their workforce according to their needs.
-internal numerical flexibility: refers to the ability of firms to adjust the working hours of staff to suit their needs.
-functional flexibility: occurs when a firm can redeploy a worker from one job to another. This requires workers to be multi-skilled
-wage flexibility: occurs when firms are able to adjust wages up and down according to the forces of demand and supply in the labour market.

Question 33

how do trade unions affect labour markets?

Answer 33

-the purpose of a trade union is to organise workers into one bargaining unit. The trade union then becomes a monopolist, a sole seller of labour, and prevents workers from competing amongst themselves in the job market.
-economic theory predicts that if trade unions raise wage rates for their members, then employment and output will be lower in otherwise competitive markets. So free market economists argue that govs must intervene to curb the power of trade unions

Question 34

how does migration affect labour markets?

Answer 34

-in recent years, there has been significant net migration into the UK of people of working age.
-net inward migration of working age people increases the potential size of the labour force. With increased supply of labour, wage rates should be lower than they would otherwise have been. If the economy is at full employment, this helps reduce inflationary pressures.
-however, the exact impact on wages in individual occupations and on economic growth as a whole is more difficult to determine.

Question 35

how do minimum wages affect labour markets?

Answer 35

-in many countries, there is a national minimum wage. In the USA, individual states can also set a higher minimum wage for their state than the national minimum wage set in Washington, the capital. It would be equivalent to paying a different minimum wage in London than in the rest of the UK.
-free market economists argue that minimum wages create unemployment and tend to argue that they should be abolished. The higher the wage rate, the less demand there will be for workers from employers.
-other economists argue that the impact on employment depends on the level at which the minimum wage is set. For the UK, there is little evidence to suggest that minimum wage levels create any significant unemployment.
-there is also an argument that a higher minimum wage can lead to supply-side improvements. Higher minimum wages encourage employers to train low paid workers to be more productive in order to justify the expense of employing them. It also encourages firms to invest in physical capital to replace low-paid workers.

Question 36

what affect does a more productive workforce with higher levels of human capital have on long run aggregate supply?

Answer 36

it will raise long run aggregate supply

Question 37

what would an interventionist approach to education be? what would a free market approach within a state-funded system be?

Answer 37

-it would be for the government to set a curriculum, prescribe teaching methods and then set targets.
-a free market approach within a state-funded system is for the gov to allow schools to compete for pupils, set their own curriculum and decide on their own teaching methods

Question 38

why do govs tend to intervene in the training market?

Answer 38

-this is because training may give rise to failure.
-firms are responsible for training their own workers. This is a cost to the firm and they may provide less training than the socially optimum level of training for the whole economy. So for this reason govs intervene.

Question 39

what would a market-based approach to training workers be? what would an interventionist approach be?

Answer 39

-it would be for government to give subsidies to firms for training.
-an interventionist approach would be for government to provide training itself, e.g. through further education colleges. It could also set up training schemes working in cooperation with firms

Question 40

what is one way to improve the average skills level of the workforce?

Answer 40

one way is to encourage immigration of individuals with above average skills.

Question 41

why is infrastructure important for promoting economic growth, give an example?

Answer 41

-poor roads, for example, lead to longer journey times for goods being transported and for workers to get to work. This adds costs to firms, making them less internationally competitive and creates labour immobility.
-a lack of good school buildings can harm education. Poor hospitals lead to more illness and death of workers, destroying the human capital of the economy.

Question 42

who does infrastructure tend to be the responsibility of?

Answer 42

of the government
-they have to set priorities for spending, deciding which projects will go ahead and which will be shelved.

Question 43

why are small and medium sized businesses important in the economy?

Answer 43

because they can provide new jobs and become the big businesses of tomorrow

Question 44

how do govs encourage the setting up of small and medium-sized businesses?

Answer 44

through various schemes such as providing training or benefits to those who become self-employed.
-‘red tape’ is often less than for large firms.
-government may also directly or through the banking system offer loans at better than commercial terms to small and medium-sized businesses

Question 45

what are the disadvantages of supply-side policies?

Answer 45

-the extra productive potential is dependent on the success of the policies in place. Individual supply-side policies may not work, and at worst, could reduce the rate of growth.
-if long run aggregate supply increases at the same rate as AD, then there will be no inflation. So in order for the Bank of England to maintain its inflation target of 2%, supply-side policies need to be pushing the LRAS curve to the right at a slightly slower pace than the increase in AD
-many supply-side policies are designed to reduce unemployment. However, supply-side policies on their own cannot guarantee low unemployment.
-successful supply-side policies in general could lead to an improvement or a deterioration or have no effect on the current account balance.
-some market-orientated, supply-side policies lead to a widening of the distribution of income.
-deregulation and privatisation too tend to lead to growing inequality because workers in the industries affected tend to see their wages fall in real terms after privatisation and deregulation have taken place.