Supply side policy issues

Learning Outcome: To understand the issues of using supply side policy

Supply side policies Supply side policies are government

policies designed to increase the productive potential of the economy and push the long run aggregate supply curve to the right

They affect the economy in 4 main ways May increase the supply both of the

quantity and quality of labour May raise the amount of capital

employed or to the introduction of more technologically advanced capital

May lead to further exploitation of natural resources such as oil deposits or agricultural land

May increase the efficiency with which the factors of production are combined

Labour productivity and unit labour costs

Supply side policies may affect both labour productivity and unit labour costs

A firm introducing new technology may need less labour and output per worker will increase

If the average wage rates do not change the cost of labour per unit will fall

The firm would now be more competitive

If all firms use the same technology relative competitiveness will remain the same

Labour productivity and unit labour costs

As an economy grows productivity will rise

More and more capital will be used by labour to produce goods and services

Workers will become better trained and have more skills

Unit labour costs for the whole economy may stay the same because increases in productivity will be matched by increases in wages

Karl Marx (19th C) predicted that all the benefit of the increase in labour productivity would go to the owners of capital

History shows this not to have been the case

Labour productivity and unit labour costs

Unit labour costs in individual industries and occupations may change over time

If a good or service is not traded internationally and there is a lack of domestic competition labour costs may rise

Labour costs in the NHS and schools have risen substantially over time

When there is a lot of competition unit labour costs tend not to rise as fast

If they get too high the industries become less competitive and production may cease

Falling unit labour costs in the third world led to a decline in the UK textile industry in the second half of the 20th Century

Labour productivity and unit labour costs There are a variety of supply side policies which

can be used to increase labour productivity Policies that lead to better education and

training of workers Either they become more productive at the

same job or are able to do more complex jobs that create higher value products

Policies could include reforming the vocational education system

Tax incentives to firms for spending on training young people

Giving workers training vouchers to spend on training courses

Policies which lead to higher levels of physical investment that will increase the amount of capital per worker E.g. government grants to firms for

investment Tax incentives to invest Government loads at below the commercial

rate of interest for investment

Flexible Labour Markets If labour markets are highly flexible

there will be rapid changes in demand and supply

As a result the natural rate of unemployment will be very low

If labour markets are highly inflexible external shocks will lead to long term disequilibrium

The natural rate of unemployment will be high

There are many ways to classify types of labour market flexibility

One way is to classify according to the strategies that companies use to manage their workforces External numerical flexibility Internal numerical flexibility Functional flexibility

Labour market flexibility – the degree to which demand and supply in a labour market respond to external changes such as changes in demand for a product or population changes to return the market to equilibrium

Flexible Labour Markets External numerical flexibility In a completely flexible labour

market firms can hire and fire workers at any time

They can adjust the numbers on a day to day basis

Modern labour markets prevent this Law gives employment rights Trade unions threaten industrial action Some countries make it very difficult to

sack permanent workers This raises the cost of permanent hire

and tends to increase numbers of temporary workers

When there is less flexibility less workers will be employed

This may lead to an increase in capital intensity of production

Flexible Labour Markets Internal numerical flexibility In a completely flexible labour market

firms can adjust the number of working hours their staff work to suit their needs

It can change shifts from day to night if necessary

It can cancel holiday leave In practice firms are restricted in their

internal flexibility by both employment law and by workers and their trade unions

Custom and practice means that employees tend to work relatively fixed hours

Firms use a wide variety of schemes to give greater flexibility e.g. overtime

Flexible Labour Markets Functional flexibility This occurs when a firm can redeploy a

worker from one job to another The workers have to be multi skilled Traditionally trade unions have resisted

functional flexibility because they argue it rates unemployment

Countries where functional flexibility is common are likely to be more competitive

Wage flexibility Firms that can adjust wages up and down

will be more competitive In practice most workers are on fixed wage

contracts Wage flexibility can be achieved by using

bonuses or individual pay bargaining It is more flexible now in the UK than 30

years ago because there is less union power

Flexible Labour Markets There are many other types of labour

market flexibility Geographical flexibility – willingness of

workers to move areas to get jobs The UK has a relatively high level of

mobility compared to the rest of EU Industrial flexibility – willingness of workers

to move from industry to industry Some argue that flexible labour markets

are one of the key reasons why the US and UK economies performed well in the decade prior to the recession compared with some EU countries that have much less flexibility

These countries have more labour laws and union power

Less flexible labour markets do tend to have higher levels of unemployment

Incentives at the margin Tax at the margin is tax paid on every extra £

earned Neoclassical economists argue that

incentives at the margin can significantly change behaviour

Cutting marginal rates on income tax leads to a significant rise in the number of hours worked

It gives an incentive for those not working to get a job

Giving income tax rebates to those who save for a pension encourages people to pay into a pension plan

Cutting unemployment benefits will encourage the unemployed to get a job

The more progressive the tax and benefit system the less incentive individuals have to work

There is a strong economic case to make the tax and benefit system more regressive

Marginal tax rate

Income earned

20% 0-37k

40% 37k to 150k

50% 150k plus

Progressive tax - A tax system in which those who earn higher incomes pay a higher percentage of their income than those with lower incomes

Regressive tax - A tax system in which those who earn lower incomes pay a higher percentage of their income

Incentives at the margin Marginal tax rates are not the only

influence on employment Many who currently do not have a job

face major obstacles to gaining a job Single people with young children

may have difficulties getting good child care

People that are physically or mentally disabled may find it difficult to find a job which is manageable for their type of disability

The Netherlands and Sweden have better systems to deal with these issues but they are expensive to run

Migration In recent years there has been significant net

migration into the UK of people of working age

This increases the potential size of the labour force

When there is an increase in the supply of labour wage rates may fall

If the economy is at full employment this helps inflationary pressures

The exact impact on wages in individual occupations and on economic growth as a whole is more difficult to determine

If all the migrants were plumbers there would be downward pressure on the earnings of plumbers but little impact elsewhere in the economy

Some have said that the UK could benefit from net immigration by targeting particular types of immigrants (highly skilled and highly qualified)

Taxation and Investment The level of taxes on businesses

(corporation tax) has an impact on investment and therefore long run AS

An increase reduces firm profitability

Fewer investment projects will be undertaken

Affects both domestic and foreign investment (FDI)

A country can raise inward levels of FDI by lowering taxes

Many argue that the high economic growth in Ireland in the 1980s was due to low business tax

Taxation and Investment Governments place high taxes on business

for 3 possible reason Government spending as a proportion

of GDP may be high – the tax finances the spending

If there is higher tax on business the tax on individuals can be lower

In the short term government may be forced to raise tax when in financial difficulty

Free market economists tend to argue that business taxes should be low

It encourages investment and leads to high economic growth

It will encourage FDI Some argue that tax is only a small part of

investment decisions and that levels of business tax are a relatively unimportant in the supply policy mix

The contribution of demand side policies

Good economic management of the economy by government which minimises fluctuations in AD has significant supply side benefits for two main reasons Macro economic stability helps economic

agents to make decisions; if the economy is stable there are high levels of investment, more labour mobility and higher consumer spending

When there is low demand in recession it can lead to both physical and human capital being destroyed; equipment is not needed and people become long term unemployed

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Essay Practice Compare the Effectiveness of Supply side

and Fiscal Policies to Correct deficits on a country’s current account of the Balance of Payments (25)

Plan your essay (20 mins) Think about what the question is asking –

which is best supply side or fiscal? Be prepared to share your plan (or part of

your plan) with the rest of the class Don’t forget to include evaluation points in

your plan (don’t wait until the conclusion to evaluate)

Essay Practice• Define Current account deficit - means the country imports a greater

value of goods and services than it exports.• To reduce a current account deficit we need to either increase

exports and or reduce imports.• Supply side policies aim to increase the productivity of the economy. • If the manufacturing sector becomes more productive, the relative

cost of British goods will fall and therefore they will become more competitive.

• This will help increase exports and reduce the current account deficit.

• Always give a couple of examples….• government could increase spending on education and training.

– Vocational training schemes may help increase labour productivity because workers will have more skills.

– A more productive workforce can improve the competitiveness of UK Exports.

• Alternatively, the Government could introduce a free market supply side policy such as reducing the power of trades unions.– If unions are powerful, productivity may be lower due to frequent strikes

and disruptive working practises such as working to rule.– If union power is reduced it helps reduce time lost to strikes, increases

labour market flexibility and therefore should help increase UK exports.

Essay Practice• Evaluation• The problem of supply side policies is that they will take

time to have effect.• Again give an example• spending on education and training may take several

years before the effects are noticed.• Also, there is no guarantee that education spending may

actually increase labour productivity• The money may be misspent or the workers may not

want to learn.• Show UK knowledge• In the UK, trades unions are no longer very powerful, so

this policy would only have limited impact.• Also, some argue trades unions can actually help

introduce new working practises and thereby increase productivity.

Essay Practice• Now look at fiscal• Current account deficits often occur during times of

economic growth and therefore• high consumer spending on imports.• Fiscal policy can be used to reduce consumer spending

and therefore reduce demand for imports.• For example• Higher income tax would reduce consumer’s disposable

income and therefore reduce imports.• UK knowledge• In the UK, consumers have a high marginal propensity to

import (people spend a high % of extra income on imports), therefore, a reduction in disposable income would have a big impact in reducing import spending.

• Deflationary fiscal policy would also reduce inflation and help to make UK goods more competitive.

Essay Practice• Evaluation• However, the problem with using fiscal policy is that• it will conflict with other macroeconomic objectives• Higher taxes will reduce growth and could cause

unemployment (explain)• Furthermore, unemployment and growth are considered

more important than the current account deficit.• Also fiscal policy doesn’t address the fundamental

underlying problem, which is a lack of competitiveness.• This needs to be addressed through supply side policies.• Now directly answer the question• Deflationary Fiscal policy may be good in a boom when

the economy is expanding too fast. However, in the long term supply side policies are best solution to addressing poor competitiveness.