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Government Policies » Supply-Side Policies

What you'll learn this session

Study time: 30 minutes

Edexcel spec: 2.1.2 (c)

What supply-side policy is and how it raises productivity and total output
How the seven supply-side policies work
How each policy affects macroeconomic objectives
How to write a clear chain of reasoning in the exam

This topic is examined on Paper 2: Macroeconomics and the Global Economy.

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What is supply-side policy?

Fiscal policy and monetary policy mainly change how much people and firms want to spend. Together they change total demand in the economy. Supply-side policy is different. It tries to make the economy able to produce more. It works on the supply side, not the demand side.

Key terms:

Supply-side policy: government policy that aims to increase the economy's ability to produce goods and services, by improving productivity and raising total output.
Total output: the total amount of goods and services produced in the whole economy.
Deregulation: removing or reducing government rules and restrictions on how businesses can operate or on who can enter a market.
Infrastructure: the basic networks a country needs to work, such as roads, railways, ports, broadband and power supplies.
Regional policy: policies to boost regions with high unemployment, for example by encouraging firms to set up there.

Productivity and total output

You already know that productivity is output per worker or per input. Supply-side policies try to raise it. If each worker, machine and unit of land produces more, the same resources make more goods and services, and total output rises.

Remember the production possibility frontier (PPF). A supply-side policy that works shifts the whole PPF outwards. To draw it in the exam, label the axes with two goods, draw the original curve and label it PPF1, then draw a second curve further out from the origin and label it PPF2. The economy can now reach points that were unobtainable before. This is positive economic growth, and it raises the economy's potential to produce in the long run.

The key difference from fiscal and monetary policy is that supply-side policies take time. Building a road or training workers can take years, so the effects are usually long-term.

The supply-side policies

Spending on infrastructure like high-speed rail is a supply-side policy that raises the economy's capacity

The spec lists seven policies, grouped here into six boxes (the two tax policies share one box). For each one, learn what it does and why it should raise output.

🏢 Privatisation

Selling state-owned firms to private owners. Private firms want profit, so they may cut waste and work harder to keep customers. Costs fall and output may rise. (The effects on different groups are covered in the lesson on Privatisation.)

✂ Deregulation

Cutting rules that make it hard to start or run a business. Easier entry means more competition, so firms have more reason to be efficient and to lower prices. Less paperwork also cuts costs.

🎓 Education and training

Better schools and training make workers more skilled, so each worker produces more per hour. (Why this improves labour quality is covered in the lesson on Labour Quality and Human Capital.)

🗺 Regional policies

Help for areas with high unemployment, such as grants or tax breaks for firms that open there. Unemployed workers get jobs, so unused resources are put to work and total output rises.

🛣 Infrastructure spending

Government spending on roads, railways, ports and broadband. Goods and workers move faster and more cheaply, so firms' costs fall and output rises.

💰 Tax incentives

Lower business taxes leave firms with more profit to invest in machines and new technology. Lower income tax rates mean workers keep more of each extra pound earned, so more people may choose to work or work longer.

The impact on macroeconomic objectives

If supply-side policies increase total output, they can help to meet several objectives at once.

Economic growth: more output means higher GDP, and the PPF shifts outwards.
Unemployment: regional policies, training and new investment can create jobs and help people into work. Lower income tax may bring more people into the labour force.
Inflation: if firms produce more at lower cost, prices can stay lower. Supply-side policies can therefore reduce cost-push pressures.
Current account: if home firms produce goods more cheaply and to a better standard, more may be exported and fewer imported.

Unlike a cut in VAT or in interest rates aimed at boosting spending, a policy that raises capacity can help growth without pushing up prices, because the economy's capacity grows as well.

Evaluating supply-side policies

Training schemes take years to pay off, one drawback of supply-side policies

Examiners reward both sides of the argument. Here are the main points.

Strengths: they can raise long-run growth, lower unemployment and keep inflation low at the same time.
Weaknesses: they are slow, and some are expensive. Education, regional help and infrastructure all need government spending, which may mean higher taxes or borrowing.
Uncertain results: lower tax rates may not make people work more. Deregulation may reduce protection for workers, consumers or the environment. Privatisation can raise prices if a private firm has little competition.

Worked example

Country Kelmar has high unemployment in its northern region and slow, crowded roads. The government builds a new motorway and offers tax breaks to firms that open factories in the north.

Step 1: the motorway cuts delivery times, so firms' transport costs fall.

Step 2: the tax breaks attract new factories, which create jobs for unemployed workers.

Step 3: more people are working and costs are lower, so total output in Kelmar rises and its PPF shifts outwards.

Result: economic growth is higher and unemployment is lower. The cost is government spending on the road and tax revenue given up.

Common mistakes

Mixing up supply-side policy with fiscal or monetary policy. Supply-side policy aims to raise the economy's ability to produce, not just spending.
Expecting quick results. Most supply-side policies take years to work.
Saying a policy "increases supply" without explaining how. Write the chain, for example: training, more skilled workers, higher productivity, more output.
Writing only the good points. Add a cost or a limit, such as the expense or the time delay.

Exam-style question

Country Dunmara has slow growth and high unemployment in its coastal towns. The government spends on new railways and broadband, and cuts the tax rate paid by firms on their profits.

(a) Define the term 'supply-side policy'. [2 marks]

(b) Identify one example of infrastructure from the information. [1 mark]

(d) Analyse how the new railways and broadband may increase total output. [4 marks]

Model answer

(a) Supply-side policy is government policy (1) that aims to increase the economy's ability to produce goods and services, for example by raising productivity (1).

(b) Railways or broadband (1).

(c) Firms keep more of their profits after tax (1), so they have more money to spend on machines or new technology (1). The investment is more worthwhile because they keep more of the extra profit it earns (1).

(d) Railways and broadband reduce firms' costs of moving goods and communicating (1), so they can produce more at a lower cost (1). Workers and goods reach firms faster, which raises productivity (1). Higher productivity means the economy produces more from its resources, so total output rises (1).

Exam tip

In an 'analyse' part like (d), link each step with 'so' or 'which means', and finish by mentioning total output, as the question asks.

Recap

Supply-side policy aims to increase the economy's ability to produce, by raising productivity and total output.
Successful policies shift the PPF outwards, giving long-run growth.
The seven policies are privatisation, deregulation, education and training, regional policies, infrastructure spending, lower business taxes and lower income tax rates.
They can help growth, unemployment, inflation and the current account, but they are slow and some are costly.

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