Evaluating the impact of supply-side policies

Overview

Effect of successful supply-side policies on economic growth, supply-side policies help to control inflation and time lags such a serious limitation on supply-side policy.

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Questions from this subtopic

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1. 1

   Analyse the effect of successful supply-side policies on economic growth.

   Model answer

   By raising the quantity and quality of the factors of production and the efficiency with which they are combined, these policies increase the output the economy is capable of producing, so the long-run aggregate supply curve shifts right and the sustainable growth rate rises. This is growth in productive potential rather than a temporary recovery of unused capacity, so it can continue year after year without running into a capacity ceiling. The qualification is that the effects arrive slowly and are difficult to attribute, since many other influences on growth are changing at the same time.

2. 2

   Which type of unemployment do supply-side policies address, and why does that matter?

   Model answer

   They address structural unemployment, which arises from a mismatch between the skills, location or attitudes of the unemployed and the requirements of available vacancies, and frictional unemployment, which arises from the time taken to search for a job. Retraining, help with mobility, better information and stronger work incentives all reduce these. They do not address cyclical unemployment caused by a shortage of aggregate demand, which is why a government facing a recession needs demand-side measures first and supply-side measures for the longer term.

3. 3

   How do supply-side policies help to control inflation?

   Model answer

   By raising productive capacity they allow the economy to meet a higher level of demand without firms bidding against one another for scarce labour and materials, so demand-pull pressure is relieved. By raising productivity they lower unit labour costs, so wage increases can be absorbed without price rises, which relieves cost-push pressure. On a diagram with the general price level on the vertical axis and real national output on the horizontal, the aggregate supply curves shift right and the equilibrium price level falls, and unlike a tightening of monetary policy this is achieved with more output rather than less.

4. 4

   Identify the effects of a broad supply-side programme on different economic agents.

   Model answer

   Consumers generally gain from lower prices, better products and more choice as competition and efficiency improve. Firms gain from lower costs, better infrastructure and a more skilled workforce, though incumbents protected by regulation or by state ownership lose. Workers with skills that are in demand gain higher real wages, while those in industries exposed to new competition or losing employment protection face insecurity and may lose their jobs, and workers whose benefits are cut in the name of incentives lose income directly. The government faces lower spending on unemployment support in the long run but must fund training, infrastructure and tax reliefs in the short run.

5. 5

   Why are time lags such a serious limitation on supply-side policy?

   Model answer

   Education takes a decade or more before a pupil enters the workforce, apprenticeships several years, and major infrastructure projects a decade from decision to opening, so almost nothing shows up within the life of a single administration. This makes the policies politically unattractive relative to a tax cut or a spending announcement whose effect is immediate, and it means the electorate rarely rewards the government that paid the cost. It also means supply-side policy is useless as a response to an immediate downturn.

6. 6

   Evaluate the cost of supply-side policies to the public finances.

   Model answer

   Interventionist measures such as building infrastructure, funding training and subsidising research require large sums of public money that have an opportunity cost in other services, and market-based measures such as cutting income and corporation tax reduce revenue directly, so both approaches tighten the constraint on the rest of the budget. Supporters answer that successful measures pay for themselves over time, because a larger and more productive economy generates more tax revenue and requires less spending on unemployment support. The difficulty is that this return is slow and uncertain, so a government must commit resources now against a benefit it cannot demonstrate, which is why such spending is often the first to be cut when budgets are squeezed.

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