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❖ Supply side Policy

Supply side policy is the policy designed to increase the Aggregate Supply (AS) by improving the
workings of product market and factor market. It may increase or reduce the government intervention
in the price system. Supply side policy measures include:

● Market-based policies

Market based supply side policies focus on allowing markets to operate more freely with minimal
government intervention. They are advocated by those economists who believe in the efficiency of free
markets in allocating resources. The word “incentives” is often used with such policies, as they are
designed to increase the incentives for labor to work harder and more productively and to increase the
incentives for firms to invest and to increase productivity. These may also be described as institutional
changes as the affect the structures, institutions and “rules” that govern economic stake holders. Market
based supply-side policies include:

⮚ Policies to encourage competition such as:

▪ Deregulation

If governments have placed many regulations on the operations of businesses then this may increase
their costs of production, thereby reducing potential output in the economy. Such regulations include
environmental laws, health and safety regulations or laws concerning working hours, leave and holidays.
A reduction in the number and / or the severity of regulations will help to increase aggregate supply.

▪ Privatization

This is the sale of nationalized firms to private sector. It is argued by free market economists that
privately-owned, profit maximizing firms will be much more efficient than the nationalized firms and will
therefore increase the potential output of the economy. Nationalized firms tend to have different goals
from private firms, such as maintenance of employment or the provision of a service to an isolated
market, and this means that they may operate inefficiently.

▪ Trade liberalization

Trade liberalization increases international competition. The elimination of subsidies, tariffs and quotas
would reduce government intervention and lead to free trade. This would mean that exporting firms
would need to be more efficient in order to compete with foreign firms. The will need to increase their
efficiency and increase their investment.

▪ Anti-monopoly regulation
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Anti- monopoly regulations encourage competition by limiting the market power of any particular firm.
This increases efficiency and improves the productive potential of an economy.

⮚ labor market policies such as:

▪ reducing the power of labor unions

Trade unions work to protect the workers’ wellbeing, rights and incomes. It is perceived that trade
unions raise the costs of workers above the level that occurs in a non-union environment. Thus the
argument is that reducing trade union power will reduce the ability of unions to negotiate higher costs
of labor and therefore lower the cost of production to firms and increase the number of workers that
firms may hire.

▪ reducing unemployment benefits

If unemployed people are given generous benefits from the government, it may be argued that they will
have less incentive to find and take jobs that are available. So, if unemployment benefits are reduced
then the unemployed people will be encouraged to take the jobs available in the economy. This will
increase the size of country’s labor force which, in turn, increases the aggregate supply.

▪ abolishing minimum wages

The setting of minimum wage keeps the price of labor above that occurs in the free market. A reduction
or abolition of the minimum wage would reduce the cost of labor and thus increase aggregate supply.

⮚ Incentive-related policies such as:

▪ Personal income tax cuts

If income taxes are cut, the workers will have the incentive to work harder and become more
productive, thus increasing the potential output of the economy.

▪ Cuts in business tax and capital gains tax

A cut in business tax and capital gain tax will increase the profit of the firms. This will enable them to
invest more to increase their productive capacity. They will also be able to invest on research and
development which may lead to advances in technology. All this is likely to generate positive-supply
side benefits.
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● Interventionist policies

• Education and training

• improving quality, quantity and access to health care

• Research and development

• Provision of infrastructure

• Industrial policies

❖ Goals of supply-side policies

• Long-term growth by increasing the economy’s productive capacity

• Improving competition and efficiency

• Reducing labour costs and unemployment through labour market flexibility

• Reducing inflation to improve international competitiveness

• Increasing firms’ incentives to invest in innovation by reducing costs

❖ How are supply- side policies and demand-side policies connected?

Some supply-side policies will have demand-side effects and some demand-side policies will
have supply side effects.

● Demand-side effects of supply-side policies

Supply-side policies are, by definition, long run policy measures. That is, they are more effective
in achieving the macroeconomic objectives in the long run. However, when they are
implemented, some of them will have short-run, demand side effects.

Let us consider the market-based supply side policies. The market-based supply side policies
like reducing household income taxes and corporate taxes will also have expansionary fiscal
effects. Thus, in the short-run, they can be expected to increase aggregate demand (AD),
leading to economic growth and lower unemployment at the cost of inflationary pressure.

Interventionist policies will all have a demand-side implication since they all involve increasing
government spending. The increased government spending causes the aggregate demand (AD)
to increase in the economy and so has expansionary fiscal effects.

It should however be noted that, while the demand-side effects may be felt quite quickly, for
the most part there is a fairly lengthy time gap between the implementation of these supply-
side policies and their effect on the potential output.

● Supply-side effects of demand side policies

Demand-side fiscal policies can have supply-side effects. An expansionary fiscal policy, involving
lower household income taxes may increase the incentive to work harder and to become more
productive. This increases the potential output of the economy. In the same way, an
expansionary fiscal policy to reduce corporate taxes may lead to increased investment and /or
increased research and development. This increases the quantity and quality of resources
(factors of production).

Expansionary fiscal policies involving an increase in government spending may have strong
supply-side effects depending on the direction of spending. Any government spending aimed at
provision of infrastructures, investment in human capital such as education or health care and
increasing research and development will not only shift the aggregate demand (AD) but will
also increase the quantity and quality of resources in the long run. This will increase the
potential output of the economy.

❖ Effectiveness of supply-side policies

● Strengths of market-based supply-side policies

● Improved resource allocation

● No burden on government budget

● Constraints/ limitations of market-based supply-side policies

● Disincentive effect

The reductions in household income taxes may not lead to a great increase in the incentive to
work. When people have an increase in their disposable income, it is possible that they may
choose to work less.

● Equity issues

Reduction in household income taxes may benefit higher wage earners more than those on
lower wages and so there may be increase in income inequalities.

Moreover, reducing corporate taxes will increase the net profits of the companies and benefit
the wealthy shareholders. This may again increase income inequality.

Labor market reforms may lead to a possible reduction in living standards for low income or un-
unionized workers leading to income inequality.

● Deregulation may have a number of negative effects:

There may be negative consequences for the environment if environmental regulations are
relaxed, so that there are more negative externalities of production.

There is a potential reduction in worker safety if health and safety regulations are relaxed.
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There may be a worsening in working conditions if regulations concerning working hours are
changed.

● Privatization may not produce the desired outcome

Privatization may not have the desired results if the process is not carried out in a transparent
manner. There have been cases in some countries where nationalized industries have been sold
at prices below their true value to individuals with connections to the government. The
industries have enjoyed monopoly power, which means that there has been no incentive to
reduce costs, reduce prices or offer choices. Indeed, in some cases, there are increases in price
and reduction in supply.

● Time lags

In all market-based supply-side policies, there will be time lags involved before the effects of
the policies are filtered through to increased potential outcome.

● Strengths of interventionist policies

● Direct support of sectors important for growth

● Constraints/ Limitations of interventionist policies

● Monetary costs involved

In all interventionist supply-side policies there are significant monetary costs involved. This
creates two problems. Firstly, there is always an opportunity cost when governments spend
money. It may be the case that, in order to implement one policy, such as increased spending
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on energy infrastructure, there is inadequate expenditure on the health care system. Secondly,
the increased expenditure, if funded through borrowing, may increase the levels of government
indebtedness and have future negative effects.

● Time-lags

In all interventionist supply-side policies, there will be time lags involved before the effects of
policies are filtered through to increased potential outcome.

● Vested interests

It is inevitable that in any democracy, the extent to which different interventionist policies are
provided depends on the ideological aims of the government and the power of various interest
groups. If there are changes in government, then there may be significant changes in emphasis
on different policies.

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