Competition and innovation as supply-side policy

Overview

Stronger competition tend to raise productivity, privatisation intended to work as a supply-side measure and innovation matter for the long-run aggregate supply curve.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why does stronger competition tend to raise productivity?

   Model answer

   A firm sheltered from rivals can survive while carrying excess costs, outdated methods and weak management, because customers have nowhere else to go. When rivals exist, any firm whose costs are above the industry standard loses market share and eventually fails, so managers are compelled to eliminate waste, adopt better methods and invest. Competition also reallocates resources over time, as output shifts from less efficient firms towards more efficient ones, which raises average productivity across the industry even if no single firm improves.

2. 2

   What kinds of measure can a government use to promote competition?

   Model answer

   It can lower barriers to entry by removing licensing requirements and exclusive franchises, open public contracts to competitive tender rather than awarding them to an established supplier, and reduce tariffs and other restrictions so that foreign producers compete with domestic ones. It can require large firms to make it easy for customers to switch supplier and to publish comparable prices. It also maintains a competition authority with the power to investigate mergers that would concentrate a market and to act against firms that collude to fix prices.

3. 3

   How is privatisation intended to work as a supply-side measure, and what are the counter-arguments?

   Model answer

   Transferring a state-owned business to private ownership is intended to expose it to the profit motive and to the discipline of shareholders and potential takeover, giving managers a sharp incentive to cut costs, respond to customers and invest efficiently, which raises productivity and therefore capacity. Against this, if the firm is a natural monopoly the transfer creates a private monopoly rather than a competitive market, so gains may be captured as profit rather than passed on in lower prices, and a private owner may under-invest in assets whose returns are distant or cut services that are socially valuable but unprofitable. Whether privatisation improves outcomes depends far more on whether it is accompanied by genuine competition or effective regulation than on ownership alone.

4. 4

   Why does innovation matter for the long-run aggregate supply curve?

   Model answer

   Innovation means new products, new production methods and better ways of organising work, and each raises the output obtainable from a given quantity of labour and capital. Over long periods, improvements in technology and know-how account for a much larger share of growth in output per person than simply adding more machines. Because long-run aggregate supply represents what the economy is capable of producing, a sustained flow of innovation is the main force pushing it steadily to the right.

5. 5

   What is a research and development tax credit, and how is it meant to change firm behaviour?

   Model answer

   It allows a firm to deduct more than the actual cost of qualifying research from its taxable profit, or to receive a cash payment if it is not yet profitable, so the effective price of doing research falls. Cheaper research means projects that were marginal now clear the firm's required return, so more research is undertaken, and the cash element is especially valuable to young firms that have promising ideas but no profits to offset. In the UK since April 2024 the main scheme gives a credit worth 20% of qualifying spending instead. The intention is to move private research spending closer to the level that would be socially optimal.

6. 6

   Why does a free market tend to under-provide research and development?

   Model answer

   Research generates positive externalities, because once an idea exists other firms can learn from it, imitate it and build on it, so the social benefit exceeds the private benefit the innovating firm can capture. Research is also risky and its returns are distant, so firms facing shareholders who want quick returns may not fund it, and small firms may be unable to borrow against an uncertain payoff. Since firms base decisions on private benefit alone, less research is undertaken than is socially desirable, which is the justification for tax credits, grants and public science funding.

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