Edexcel IAL Economics Unit 2 Revision Notes

Macroeconomic supply-side policies

1. Definition & Graph

Supply side policies: government policies designed to increase the productive potential
of the economy and push the long-run aggregate supply curve to the right.

OR

2. Types of supply-side policies

Market based policies (a.k.a free market policies): policies designed to remove
barriers to the efficient working of free markets.

■ Promoting market competition

Purpose: to incentivize firms to use resources more efficiently
o Firms will minimize costs of production, while maintaining a high-quality product
o Firms will be on pressure to speed up innovation to compete with other firms
o Shareholders will be will be more willing to spend profits on R&D, rather than
distribute them as dividends.
Ways to promote market competition:
o Product market deregulation: the process of removing government controls from
markets of goods and services, e.g. the government allows any bus company to
offer services along a route.
➔ Good: it will encourage more firms to provide goods and services at a lower
price
➔ Bad: it will also increase inequality between regions as firms are only
providing services in the most profitable areas of the market.
o Privatisation: sale of government organisations or assets to the private sector.
à Good: government-run organisations have little incentive to cut costs, but the
privately-owned companies aim for profit maximization. They will have greater
incentive to lower cost and use resource more efficiently.
➔ Bad: 1) private firms prioritise profit before social purposes of providing goods

Supply-side policy 1/5

 and services; 2) Monopoly may arise under free market competition, leading
to restricted output level and higher price
o Competition policy: designed to increase competition in markets, reducing the
power of monopolies and making cartels and price fixing agreements illegal.

■ Reduce taxation
o Reduce marginal tax income: marginal tax income measures how much
additional tax a worker needs to pay when you get more income from additional
hour of working. A lower rate means less paid in tax from additional overtime
payment received.
➔ Good: workers are more willing to work overtime and put more efforts;
employers have more incentive to employ workers for production due to
lower hiring cost.
➔ Bad: widen the income gap between the rich and the poor, and harm the well-
being and happiness of poor people.
o Reduce corporation tax: corporate tax is a tax on company profit.
➔ Good: firms will receive higher after-tax profit 1) to be reinvested into better
technology; 2) to incentivize labour force by paying out bonuses to hard-
working workers. This will further improve labour productivity.
➔ Bad: 1) the local government may lose an important tax revenue stream; 2)
Empirical evidence suggests that there will be little impact on incentives if
marginal corporate tax is 20% or 30%. The incentive effect works better for a
high marginal corporate tax level such as 80%.

■ Reduce welfare payment: high unemployment benefit may cause poverty and
unemployment trap.
o Poverty trap occurs when an individual is little better off or even worse off when
gaining an increase in wages because of the combined effect of increased tax
and benefit withdrawal. This adversely affect an individual’s incentive to work
harder for job promotion.
o Unemployment trap occurs when an individual is only little better off or is even
worse off getting a job than staying unemployed because of loss of welfare
benefits and taxation. This adversely affect an individual’s employment decision.

Therefore, one solution is to cut welfare benefit and cut income tax.

➔ Good: 1) encourage workers to take high-paid jobs; 2) prevent some people

to deliberately stay unemployed to avoid losing welfare benefits and paying
income tax; 3) avoid workers to be de-skilled and out-of-date after a long
period of unemployment.
➔ Bad: 1) reduce welfare payment may hit the poor, widening income gaps; 2)
reduce income tax means government receives lower tax revenue.

■ Cut costs of bureaucracy for firms: reduce rules and regulations (a.k.a red tapes).
➔ Good: 1) reduces cost of production for firms; 2) encourage entrepreneurs to
set up.
➔ Bad: reducing filing procedures on food safety and health will harm the well-
beings of consumers.

■ Deregulate labour market: removing government controls on labour market

o Cut minimum wages: minimum wage creates unemployment. The higher the
minimum wage, the less the demand for workers from employers. This will
therefore limit the supply-side of an economy.
Supply-side policy 2/5
 However, in some cases, higher minimum wage can also lead to supply-side
improvements due to:

1) Minimum wage encourages employers to train their low-paid workers to be

more productive in order to justify the expense of employing them.
2) Minimum wage encourages firms to invest in physical capital to replace low-
paid workers. Higher investment will lead to economic growth.

o Weaken the power of trade unions: trade unions are responsible for organizing
workers into one bargaining unit. If trade unions raise wage rates for their
members, then employment and output will be lower in a competitive labour
market.

Ways to reduce trade union power：

1) limit the ability to organize strikes
2) company-level agreements on things such as wages, overtime pay and
working hours should exist rather than industry level agreements

Problems of reducing trade union power:

1) worker exploitation may exist
2) might not be effective if trade unions have little industrial power

o Other supply-side changes to legal employment laws:

1) reducing redundancy fee à reduce the cost for firms when sacking workers,
incentivize workers to work hard to avoid being unemployed
2) ability for firms to have flexible hour contracts
3) remove maximum working hours per week à increase supply of labour
hours by asking workers to work overtime
4) Migration policy: easing procedures to apply work visa will attract more
immigrants into a country à boosting labour supply especially the top
talented workers. However, on the other side, an increase in labour supply
will also increase unemployment.

Interventionist policies: it involves government intervention into free markets to correct

market failure.
■ Invest in education, training and skills
o Education: the social benefit from consuming education is greater than the

:
private benefit, so education is always under-consumed in a free market.
Government intervention (e.g. student loans and subsidies to universities) are
required to increase consumption to the socially optimal level. However,
empirical evidence suggests that education is less well funded in developing
countries than in the developed countries.
o Training: although training is a merit good as it helps to improve labour
productivity, firms are less willing to organize additional trainings for workers as
organizing training courses will incur additional costs. Government will directly
provide training courses itself, or subsidize firms to do so.
■ Boost incentive to encourage investment: investment on R&D leads to technological

Supply-side policy 3/5

 progress and encourages innovation. Government can use tax relief or subsidy to
achieve this.

Problem:
1 ） Both tax relief and subsidy are difficult to administer, and may incur high
administration cost
2） Corruption issue – firms can bribe government officials to apply for additional
subsidies and take up social resources illegally. This can reduce net economic
welfare.
3 ） It is difficult to guarantee whether the government subsidy is well spent on

③ investment project
■ Infrastructure investment: spending on building new roads, schools and hospitals etc.

Problems:
1) Time-consuming
2) Costly, big challenge to budget control and project management
3) Conflicts with other government objective – when an infrastructure project is funded
by government, the government will need to raise tax revenue or to reduce
expenditure in other sector, in order to support additional expenditure on
launching these infrastructure projects.

■ Support for start-ups – for small- and medium-sized businesses: through 1) providing
trainings or tax relief to these companies; 2) to offer lower interest rates and better
borrowing terms through banking system

■ Regional policies: refers to government policies that focus on specific regions to

improve job creation, the growth of new businesses and to improve business
competitiveness. This includes providing grants for firms who set up in these regions,
tax incentives, government spending on infrastructure in these regions.

Problem: government failure – government may misallocate resources

3. Effects of supply-side policy

■ Economic growth: LRAS shifts out, higher productive potential given successful
policies in place.

■ Inflation:
o Assume aggregate demand remains constant, a shift in LRAS will lower price level
and decrease inflation. It makes domestic goods become more price competitive
internationally, boosting export revenue.
o However, some supply-side policies such as investment into R&D, education and
infrastructure projects will also lead to increase in AD. If AD increases to the same
degree as the LRAS does, then the price level will remain constant

Supply-side policy 4/5

 ■ Unemployment
o If an economy is at full employment, then supply-side policies will create more
employment opportunities as real GDP rises in the long term.
o If an economy is experiencing negative output, then an increase in LRAS will
increase the unemployment rate, unless actual growth keeps pace with potential
growth.

■ Current account equilibrium (uncertain)

o Supply-side policies can lead to an improvement, a worsening or have no effect on
current account equilibrium. The effect will depend on total impacts to export and
imports.
➔ Impacts to export: Supply-side policies on are more successful in lowering
price level or improving product quality, then it is more likely to cause export-
led growth
➔ Impacts to import: supply-side policies will cause an increase in national
income, so households will get more disposable income to spend. This will
increase consumption of imports. Also encouraging foreign businesses to
set up domestically will also increase imports expenditure on imported
machines and equipment.

■ Distribution of income (uncertain)

o More jobs and more income will reduce income gap
o Some supply-side policies lead to a widening of the distribution of income, e.g.
lowering minimum wages, cutting welfare benefits and reducing trade union power.
o High-income earners benefit disproportionately to low-income earners

Supply-side policy 5/5