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Supply-side economics, which gained popularity around the 1970s, argues that sustainable economic growth comes from the supply of goods and services in the economy, or in other words, production. The idea behind supply-side economics is that the output of the economy will drive economic growth. Now let’s explore this theory and its implications in detail.
Supply-side policies are policies that aim to increase productivity and efficiency in the economy. The objective of supply-side policies is to increase the productive potential of the economy and to increase trend growth rates. Rather than the government directly generating economic growth, supply-side policies focus on achieving this growth through market-based forces.
Trend growth rate is the long-term average growth rate of a country's economy over time.
Productivity is a measure of how effectively the economy can use a set of inputs to create a volume of outputs.
Efficiency occurs when all resources and factors of production are allocated in an optimal way, meaning that they create the most value with minimal waste.
The aim of such policies is to boost aggregate supply (AS) to result in increased output. In this case, the long-run aggregate supply (LRAS) curve shifts to the right, and the national output levels, or real GDP, increase (see Figure 1 below).
The idea is that the increased output of the economy (higher levels of aggregate supply) will drive economic growth. Supply-side policies aim to remove market imperfections to make production more efficient, which can help reduce inflationary pressures. They also aim to encourage the free flow of labour and capital by reducing restrictions in the economy.
Figure 1. The shift in long-run aggregate supply, StudySmarter Originals
Supply-side economists argue that real economic growth comes from the supply-side of the economy (aggregate supply). From this point of view, government policies should focus on creating the conditions that encourage the market to achieve equilibrium through market forces rather than through stabilisation. This is the notion behind market-based or free-market supply-side policies.
On the other hand, interventionist supply-side policies follow the idea that the free market economy can’t achieve the desired objectives by itself without any government intervention. From this point of view, interventionist policies are necessary to increase the total output of the economy.
There are several types of interventionist supply-side policies:
There are two ways the government can invest in human capital:
Investing in education and training programs: the investment in education and training of the workforce can improve the quality and productivity of labour, leading to economic growth. This results in the LRAS curve shifting to the right as workers’ skills and productivity increase.
Investing in improving healthcare: as people have access to a better quality healthcare system they become healthier, take fewer sick days, and become more productive. Improving healthcare leads to many positive externalities and increases LRAS in the economy as productivity increases. Another form of health reform policy could include discouraging people from pursuing unhealthy behaviors like using tobacco or alcohol by increasing taxes on these types of goods.
Investing in new technology can also boost the output of the economy. Governments are often involved in research and development (R&D), in addition to creating incentives for firms to pursue R&D by providing them with subsidies, grants, tax breaks, or patents to protect innovation. The development of new technology and technological innovation could make production processes quicker, less costly, and more efficient. This increases the total productivity, output, and efficiency in the economy and shifts the LRAS curve to the right.
Industrial tactics include government policies that aim to encourage growth and production in a certain industry. These can include:
Providing support to small businesses.
Providing support to emerging industries.
The government can target certain industries and business forms by providing subsidies, grants, or decreasing taxation to encourage entrepreneurship, boost production and employment, and, therefore, economic growth and output.
Other policies include creating affordable housing, which can make it easier for people to relocate and move from less expensive to more expensive areas (like larger cities) and find jobs in industries that are facing labour shortages.
Finally, investing in infrastructure, like roads or transportation, can increase productivity by lowering costs and saving time on the transportation of goods and services. It also makes it easier for people to commute, which can increase productivity.
Now let’s take a look at some market-based supply-side policy examples.
Competition-based policies aim to encourage competition within the economy. If competition is higher among firms, they will have to reduce costs, leading to higher production efficiency and a more efficient allocation of resources.
Productive efficiency occurs when the economy is operating at its maximum capacity. This means that the economy can’t produce more of one good without sacrificing the production levels of another good.
Allocative efficiency occurs when the economy is producing goods and services in a way that matches consumer preferences. This means that all goods, services, and capital are distributed effectively and all resources are used in a way that is deemed most profitable.
There are a few ways in which the government can encourage competition in the economy:
Deregulation: the removal of regulations in certain industries. One of the ways to do this is by removing the protections the government provides for certain firms. This removes barriers to entry, making it easier for new firms to enter the market which often leads to decreased prices and increased quality of goods. Deregulation can also involve the removal of certain regulations which are in place to protect consumers (like worker protection or environmental regulations). Although this might benefit the free-market economy, the social costs of removing such regulations might be high, which makes this strategy questionable.
Deregulating financial markets increases competition between banks and financial institutions, as it allows for foreign competitors to enter the market as well.
Privatisation occurs when the government sells its previously state-owned assets to private individuals or companies. The idea is that companies in the private sector are more likely to be profit-oriented, which can lead to a more efficient allocation of resources.
Marketisation or commercialisation involves transferring the provision of goods and services previously run through public control to the market sector. It introduces competition to the public sector.
Trade liberalisation involves the reduction of trade barriers between different countries. Free trade leads to increased competition and more efficient use of resources.
Anti-competitive behavior: governments can change legislation for monopolies to reduce the likelihood of anti-competitive behavior, thus encouraging competition in the industry.
Incentive-based policies include the decrease in taxation for both workers and firms. The types of incentive-based policies include:
Decreasing income taxes: by decreasing income taxes, workers will be incentivised to work more hours, as their disposable income increases. This can also incentivise those that are out of work to find work. As a result, more people in the economy are working and the total output of the economy increases, shifting the LRAS curve to the right.
Decreasing corporate taxes: corporate taxes are charges that firms pay on the profits they make. By reducing corporate taxes firms can keep more of their profits, which they can then use to invest in new technology or innovation. Increased investment leads to higher productivity and output.
Encourage saving: governments create tax privileges for saving and give individual shareholders preference to encourage saving.
Governments implement labour market reform policies to make the labour market more competitive and flexible. The objective of these policies is to reduce the natural rate of unemployment. Labour market reform includes:
Abolishing the minimum wage: having a national minimum wage above the equilibrium rate can lead to inefficiencies in the market. Therefore, by abolishing the minimum wage, wages would fall to the equilibrium rate, increasing the efficiency of the labour market.
Reducing unemployment benefits: the argument here is that reducing unemployment benefits would encourage those that are currently unemployed to find work quickly. This would reduce the natural unemployment rate.
Weakening trade union power and reducing job security: this would make it a lot easier for firms to hire and fire employees and allow for greater wage flexibility, as wages become more responsive to the effects of supply and demand.
Let’s evaluate the strengths and weaknesses of supply-side policies.
Some strengths of supply-side policies include:
Increasing productivity: supply-side policies have the ability to increase labour productivity through decreasing income taxes, increasing the mobility of labour, and through various training programs. This, in total, increases the real output of the economy.
Reducing unemployment: supply-side policies can provide workers with additional skills and education, subsidise relocation (increasing the mobility of labour), and provide workers with additional information about job opportunities. These types of interventionist policies reduce the natural rate of unemployment.
Reducing inflationary pressure: supply-side policies aim to increase the overall output and efficiency of the national economy (shifting the LRAS curve to the right). If the economy is growing, the increase in aggregate supply will be matched by an increase in aggregate demand. This means there will be minimal upward pressure on the price level (see Figure 2 below).
Impacts on equity: certain supply-side policies, like creating training and education programs for workers can increase equity and job security in the market.
Economic growth: supply-side policies aim to result in increased productivity through labour incentives and reform, which increases the overall output of the economy in the long run.
Competition: supply-side policies, including the incentives for innovation or adaptation of new technology, result in firms becoming more competitive in the market.
Figure 2. Inflationary pressure in the long run, StudySmarter Originals
Some weaknesses of supply-side policies include:
Time lag: most supply-side policies only start working after a long time. There is a time lag in between when the policy is implemented and when it starts taking effect. This means that supply-side interventions tend to start working in the long term rather than the short term.
Negative impacts on the government budget: interventionist supply-side policies involve significant public expenditure which places pressure on the government budget. Market-based policies involve the decrease in taxation, which reduces government revenue, also putting pressure on the budget.
Negative impacts on equity: certain market-based policies, like abolishing the minimum wage and deregulating the labour market, have negative impacts on equity, especially for those on very low incomes (distribution of income).
Negative effects on the environment: deregulation in certain industries can have harmful effects on the environment. For example, firms can start increasing their emissions as a result of the lack of regulations regarding their industry.
Now let's take a look at the effects of supply-side policies on the different markets.
As mentioned previously, reducing income taxes can encourage productivity, as workers are more willing to work when their disposable income increases.
Supply-side policies often focus on increasing the mobility of labour so workers can easily move from one location to another (for example from rural areas to bigger cities). This further increases productivity by influencing labour market flexibility.
As a result of the increased output in the economy, efficiency also increases due to the more optimal allocation of resources (in this case, labour).
Governments encourage firms to make supply-side improvements through subsidies and grants that encourage innovation and the use of new technologies. This can increase the performance and competitiveness of firms.
Deregulation is used to reduce the barriers to entry in certain industries and encourage new entrants into the market. This leads to increased competitiveness and efficiency in the market.
Additionally, certain supply-side policies are aimed at reducing businesses’ costs of production and reducing monopoly power. This leads to more price-competitive markets and decreases cost-push inflationary pressures.
Deregulating financial markets increases competition between banks and financial institutions, as it allows for foreign competitors to enter the market as well. This increases the supply of funds and decreases borrowing costs for companies. The removal of such controls also increases investment from abroad.
By reducing corporation taxes and deregulating markets, the government also encourages entrepreneurship and risk-taking.
Finally, by generating certain tax privileges and giving individual shareholders preference, the government encourages saving. However, if interest rates are very low, this might have the opposite effect, whereby saving is discouraged.
Supply-side theories argue that sustainable economic growth comes from the supply of goods and services in the economy, or in other words, production. The idea behind supply-side economics is that the output of the economy will drive economic growth.
In that sense, an example of supply-side economics would be a government making the decision of deregulating and industry to allow for more competition.
Supply-side policies are policies that aim to increase productivity and efficiency in the economy. The objective of supply-side policies is to boost aggregate supply (AS) to result in increased output. In this case, the LRAS shifts to the right and national output levels increase, meanwhile the price level decreases.
Governments encourage firms to make supply-side improvements through subsidies and grants to encourage innovation and the use of new technologies. This can increase the performance and competitiveness of businesses. Additionally, deregulation is used to reduce the barriers to entry in certain industries and encourage new entrants into the market. This leads to increased competitiveness and efficiency in the market.
Demand-side policies aim to achieve economic growth by targeting aggregate demand (AD), meanwhile supply-side policies aim to do this through the long-run aggregate supply (LRAS).
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