IB ECONOMICS SECTION 2 6 SUPPLYSIDE POLICIES 23

IB ECONOMICS SECTION 2. 6 SUPPLY-SIDE POLICIES

23. Explain that supply-side policies aim at positively affecting the production side of an economy by improving the institutional framework and the capacity to produce (that is, by changing the quantity and/or quality of factors of production). Supply-side economic policies are mainly microeconomic policies designed to improve the supplyside potential of an economy, make markets and industries operate more efficiently and thereby contribute to a faster rate of growth of real national output The “supply side” refers to factors affecting the quantity or quality of goods and services produced by an economy such as the level of productivity or investment in research and development.

24. State that supply-side policy may be market-based or interventionist and that in either case they aim to shift the LRAS curve to the right, achieving growth in potential output. Supply side policies are government policies which seek to increase the productivity and efficiency of the economy. They can involve interventionist supply side policies (e. g. government spending on education) or free market supply side policies (e. g. reduce government legislation) � The main macro economic objectives of the government include: 1. Higher economic growth 2. Low inflation 3. Low Unemployment 4. Equilibrium on the balance of payments To achieve all objectives simultaneously it is essential to improve the supply side of the economy. If the government can increase productivity and shift AS to the right, it can enable low inflationary growth.

24. State that supply-side policy may be market-based or interventionist and that in either case they aim to shift the LRAS curve to the right, achieving growth in potential output. Classical view of LRAS shifting to the right. Keynesian view of LRAS shifting to the right.

Interventionist supply side policies Interventionist policies: State has key role in investing in public services and building critical infrastructure Tax incentives and welfare reforms can encourage more people into work A commitment to a fair minimum wage / living wage to improve work incentives Active regional policy to boost under-performing areas / areas of high unemployment Some case for selective import controls to allow domestic industries to expand Management of the exchange rate to improve competitiveness of export industries Nationalization of some key industries Stronger regulation of industries including finance and transport

Market-base supply side policies Market-based policies: Cutting government spending and taxes and policies to cut government borrowing Laws to control trade union powers Reducing red-tape to cut the costs of doing business Measures to improve the flexibility of the labor market / reforming employment laws Policies to boost competition such as deregulation and tough anti-monopoly and anti-cartel laws Privatization of state assets (selling off public sector businesses into the private sector) Opening up an economy to overseas trade and investment Opening up an economy to inward labor migration

25. Explain how investment in education and training will raise the levels of human capital and have a short-term impact on aggregate demand, but more importantly will increase LRAS. Increased Spending on Education and Training Economists disagree about the scale of the likely economic and social returns to be earned from higher spending on education – but few of them deny that “investment in education” has the potential to raise the skills within the work force and improve the employment prospects of thousands of unemployed workers. The economic returns from extra education spending vary according to the stage of development that a country has achieved Government spending on education and training improves workers’ human capital Economies that have invested heavily in education are those that are well set for the future. Most economists agree, with the move away from industries that required manual skills to those that need mental skills, that investment in education, and the retraining of previously manual workers, is vital. Improved training, especially for those who lose their job in an old industry should improve the occupational mobility of workers. This should help reduce the problem of structural unemployment. A well-educated workforce acts as a magnet foreign investment in the economy. Improved education increases opportunities which means that incentives can

26. Explain how policies that encourage research and development will have a short-term impact on aggregate demand, but more importantly will result in new technologies and will increase LRAS. Research and Development (R&D) Investigate activities that a business chooses to conduct with the intention of making a discovery that can either lead to the development of new products or procedures, or to improvements of existing products or procedures. Research and development is one of the means by which business can experience future growth by developing new products or processes to improve and expand their operations. Capital investment and innovation: Capital spending by firms adds to aggregate demand (C+I+G+(X-M)) but also has an important effect on long run aggregate supply. Supply side policies would include tax relief on research and development and reductions in the rate of corporation tax

27. Explain how increased and improved infrastructure will have a short-term impact on aggregate demand, but more importantly will increase LRAS. Investment in infrastructure is the stock of fixed capital equipment in a country, including factories, roads, schools, etc, considered as a determinant of economic growth. Improving information and investing in infrastructure will facilitate the firms to produce more and at a more cost efficient manner. Better infrastructure attracts more investment both domestic and foreign. In the short run increase government expenditures of infrastructure will lead to rise in AD and will fuel inflation, however in the long run it will lead to greater efficiencies and output thus shifting the LRAS to the right.

28. Explain that targeting specific industries through policies including tax cuts, tax allowances and subsidized lending promotes growth in key areas of the economy and will have a short-term impact on aggregate demand but, more importantly, will increase LRAS. Improving the performance of firms Measures to improve competition and efficiency in product markets, especially in global markets, are also a significant part of supply-side policy. Example of measures include: Government may help to improve supply-side performance by giving assistance to firms to encourage them to use new technology, and innovate. This can be done through grants, or through the tax system. Deregulation of product markets may be implemented to bring down barriers to entry, encourage new and dynamic market entrants, and improve overall supply-side performance. The effect of this would be to make markets more competitive and increase efficiency. Promoting competition is called competition policy. Privatization of state industry was a central part of supply-side policy during the 1980 s and 1990 s, and helped contribute to the spread of an enterprise culture. As long as privatization is accompanied by measures to promote competition, there are likely to be efficiency gains for the firm, and productivity gains for the employees. Supply side performance can also be improved if there is a constant supply of new firms. Small businesses are often innovative and flexible, and can be helped in a number of ways, including start-up loans and tax breaks.

29. Explain how factors including deregulation, privatization, trade liberalization and antimonopoly regulation are used to encourage competition. Deregulation of Markets De-regulation or liberalization means the opening up of markets to greater competition The aim of this is to increase market supply (driving prices down) and widen the choice available to consumers Good examples of deregulation to use include: urban bus transport, post and parcel delivery service, telecommunications, and gas and electricity supply.

29. Explain how factors including deregulation, privatization, trade liberalization and antimonopoly regulation are used to encourage competition. Privatization Over the last twenty-five years, many former state-owned businesses have been privatized – i. e. transferred from the public to private sector. Privatization is designed to break-up state monopolies and create more competition. The government also created utility regulators who have in the past imposed price controls and who are now in charge of over-seeing moves towards competitive markets in areas such as gas and electricity supply and telecommunications.

29. Explain how factors including deregulation, privatization, trade liberalization and antimonopoly regulation are used to encourage competition. Toughening up of Competition Policy Most supply-side economists believe that competition forces business to become more efficient in the way in which they use scarce resources. A tougher competition policy regime includes policies designed to curb anti-competitive practices such as price-fixing cartels and other abuses of a dominant market position – in other words – intervention to curb some of the market failure that can come from monopoly power A commitment to free (open) trade Trade between nations creates competition and should be a catalyst for improvements in costs and lower prices for consumers The UK is committed to an expansion of free trade within the European Union Single Market and also negotiating a liberalization of trade in the global economy as part of its membership of the World Trade Organization.

29. Explain how factors including deregulation, privatization, trade liberalization and antimonopoly regulation are used to encourage competition. Measures to encourage small business start-ups / entrepreneurship The small businesses of today often become the larger businesses of tomorrow employing more workers and contributing to innovation that can have positive spill-over effects in other industries. Governments of all political persuasions argue that they want to promote an entrepreneurial culture and to increase the rate of new business startups. Supply side policies include loan guarantees for new businesses; regional policy assistance for entrepreneurs in depressed areas of the country;

30. Explain how factors including reducing the power of labor unions, reducing unemployment benefits and abolishing minimum wages are used to make the labor market more flexible (more responsive to supply and demand). Reducing the power of Trades Unions This should a) increase efficiency of firms e. g. less time lost to strikes b) reduce unemployment ( if labor markets are competitive) Reducing State Welfare Benefits This may encourage unemployed to take jobs. Providing better information about jobs This may also help reduce frictional unemployment Deregulate Labor Markets This is said to be an important objective to increase competitiveness. E. g. Make it easier to hire and fire workers.

31. Explain how factors including personal income tax cuts are used to increase the incentive to work, and how cuts in business tax and capital gains tax are used to increase the incentive to invest. Income Tax Reforms and the Incentive to Work Economists who support supply-side policies believe that lower rates of income tax provide a short-term boost to demand, and they improve incentives for people to work longer hours or take a new job – because they get to keep more of the money they earn. Cutting tax rates for lower paid workers may help to reduce the extent of the ‘unemployment trap’ – where people calculate that they may be no better off from working than if they stay outside the labor force. Do lower taxes always help to increase the active labor supply in the economy? It seems obvious that lower taxes should boost the incentive to work because tax cuts increase the reward from a job. But some people may choose to work the same number of hours and simply take a rise in their post-tax income! Millions of other workers have little choice over the hours that they work.

31. Explain how factors including personal income tax cuts are used to increase the incentive to work, and how cuts in business tax and capital gains tax are used to increase the incentive to invest. Reductions in business taxation - for example lowering the rate of corporation tax (to stimulate investment) or reducing employers’ national insurance contributions (to boost the demand for labor). Lower taxes for business research and development spending or tax relief for inward investment projects also have a supply-side aspect to them. capital gains tax cuts: Encourages investors to retain funds for a long period. Facilitates investment in new equipment and machinery.

32. Evaluate the effectiveness of supply-side policies through consideration of factors including time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment. time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment.

32. Evaluate the effectiveness of supply-side policies through consideration of factors including time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment. The advantages: Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and productivity gains in the product and labor markets. They can also help create real jobs and sustainable growth through their positive effect on labor productivity and competitiveness. Increases in competitiveness will also help improve the balance of payments. Finally, supply-side policy is less likely to create conflicts between the main objectives of stable prices, sustainable growth, full employment and a balance of payments. This partly explains the popularity of supply-side policies over the last 25 years.

32. Evaluate the effectiveness of supply-side policies through consideration of factors including time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment. The disadvantages: However, supply-side policy can take a long time to work its way through the economy. For example, improving the quality of human capital, through education and training, is unlikely to yield quick results. The benefits of deregulation can only be seen after new firms have entered the market, and this may also take a long time. In addition, supply-side policy is very costly to implement. For example, the provision of education and training is highly labor intensive and extremely costly, certainly in comparison with changes in interest rates. Furthermore, some specific types of supply-side policy may be strongly resisted as they may reduce the power of various interest groups. For example, in product markets, profits may suffer as a result of competition policy, and in labor markets the interests of trade unions may be threatened by labor market reforms. Finally, there is the issue of equity. Many supply-side measures have a negative effect on the distribution of income, at least in the shortterm. For example, lower taxes rates, reduced union power, and privatization have all contributed to a widening of the gap between rich

2. 6 Supply-side policies There are two broad approaches to the supplyside. Firstly policies focused on product markets where goods and services are produced and sold to consumers and secondly the labor market – a factor market where labor is bought and sold.

Supply Side Policies for Product Markets Product markets refer to markets in which all kinds of commodities are traded. Supply-side policies in product markets are designed to increase competition and efficiency. If the productivity of an industry improves, then it will be able to produce more with a given amount of resources, shifting the LRAS curve to the right.

Supply Side Policies for Product Markets Privatization Deregulation of Markets Toughening up of Competition Policy A commitment to free international trade Measures to encourage small business startups / entrepreneurship Capital investment and innovation

Privatization This involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running business because they have a profit motive to reduce costs and develop better services. Privatization is designed to break up state monopolies and create more competition. The government also created utility regulators who have imposed price controls on many of these industries and who are now over-seeing the move towards competitive markets in areas such as gas and electricity supply and telecommunications.

Deregulation of Markets De-regulation or liberalization means the opening up of markets to greater competition. The aim of this is to increase market supply (driving prices down) and widen the range of choice available to consumers. The discipline of competition should also lead to greater cost efficiency from producers – who are keen to hold onto their existing market share.

Toughening up of Competition Policy A tougher competition policy regime includes policies designed to curb anti-competitive practices such as price-fixing cartels and other abuses of a dominant market position – in other words – intervention to curb some of the market failure that can come from monopoly power

A commitment to free international trade Trade between nations creates competition and should be a catalyst for improvements in costs and lower prices for consumers.

Measures to encourage small business start-ups / entrepreneurship The small businesses of today can often become the larger businesses of tomorrow, adding to national output, employing more workers and contributing to innovative behavior that can have positive spill-over effects in other industries. Governments of all political persuasion argue that they want to promote an entrepreneurial culture and to increase the rate of new business start-ups. Supply side policies include loan guarantees for new businesses; regional policy assistance for entrepreneurs in depressed areas of the country; advice for new firms

Capital investment and innovation Capital spending by firms adds to aggregate demand (C+I+G+(X-M)) but also has an important effect on long run aggregate supply. Supply side policies would include tax relief on research and development and reductions in the rate of corporation tax. A dynamic environment with opportunities for enterprise and innovation is vital to improving economic performance. New businesses entering the marketplace increase competitive pressures facilitating the introduction of new ideas and technologies.

Supply side policies for the Labor Market Trade Union Reforms Increased Spending on Education and Training Income Tax Reforms and the Incentive to Work Eliminate price controls on labor markets (Minimum Wage laws)

Trade Union Reforms This should (a) increase efficiency of firms e. g. less time lost to strikes (b) reduce unemployment ( if labor markets are competitive)

Increased Spending on Education and Training Better education can improve labor productivity and increase AS. Often there is under-provision of education in a free market, leading to market failure. Therefore the govt. may need to subsidies suitable education and training schemes or direct provision. However govt. intervention will cost money, requiring higher taxes, It will take time to have effect and govt. may subsidies the wrong types of training

Income Tax Reforms and the Incentive to Work It is argued that lower taxes (income and corporation) increase the incentives for people to work harder, leading to more output. The Laffer curve is a representation of the relationship between government revenue raised by taxation and possible rates of taxation. It illustrates the concept of taxable income elasticity – that taxable income will change in response to changes in the rate of taxation. The Laffer curve usually postulates that no tax revenue will be raised at the extreme tax rates of 0% and 100%. If both a 0% and 100% rate of taxation generate no revenue, but some intermediate tax rate generates some tax revenue, it follows that there must exist at least one rate where tax revenue would be a non-zero maximum. The Laffer curve is typically represented as a graph which starts at 0% tax with zero revenue, rises to a maximum rate of revenue at an intermediate rate of taxation, and then falls again to zero revenue at a 100% tax rate. The actual existence and shape of the curve is uncertain and disputed.

Laffer Curve

Eliminate price controls on labor markets (Minimum Wage laws) Minimum wage laws can set wages, they cannot guarantee jobs. In practice they often price low-skilled workers out of the labor market. Employers typically are not willing to pay a worker more than the value of the additional product that he produces.

Essential Question(s): 2. 6 Supply-side policies Explain how investment in education and training will raise the levels of human capital and have a short-term impact on aggregate demand, but more importantly will increase LRAS. Explain how policies that encourage research and development will have a short-term impact on aggregate demand, but more importantly will result in new technologies and will increase LRAS. Explain how increased and improved infrastructure will have a short-term impact on aggregate demand, but more importantly will increase LRAS. Explain that targeting specific industries through policies including tax cuts, tax allowances and subsidized lending promotes growth in key areas of the economy and will have a

Essential Question(s): 2. 6 Supply-side policies Explain how factors including deregulation, privatization, trade liberalization and antimonopoly regulation are used to encourage competition. Explain how factors including reducing the power of labor unions, reducing unemployment benefits and abolishing minimum wages are used to make the labor market more flexible (more responsive to supply and demand). Explain how factors including personal income tax cuts are used to increase the incentive to work, and how cuts in business tax and capital gains tax are used to increase the incentive to invest. Evaluate the effectiveness of supply-side policies through consideration of factors including time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on

Evaluate the effectiveness of supply-side policies through consideration of factors including time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment. time lags, the ability to create employment, the ability to reduce inflationary pressure, the impact on economic growth, the impact on the government budget, the effect on equity, and the effect on the environment.