Understanding Supply Side Policy (Cambridge International A-Level Economics)

What is supply-side policy?

• Supply-side policy is government policy that aims to increase the productive capacity of the economy by shifting the Long Run Aggregate Supply (LRAS) curve to the right
• Unlike fiscal and monetary policy which operate primarily through AD, supply-side policy works directly on the supply side of the economy - increasing the quantity and quality of factors of production

Supply side policy aims to shift LRAS

• A rightward shift of LRAS means the economy can produce more output at every price level

  • The potential output increases

The objectives of supply-side policy

1. Increasing productivity

• Productivity is the output produced per unit of input - most commonly measured as output per worker (labour productivity)

  • Higher productivity means the same number of workers can produce more output - unit costs of production fall and the economy becomes more competitive internationally

• Productivity can be raised by improving the quality of labour (through education and training), improving technology (through R&D investment) or improving management practices

2. Increasing productive capacity

• Productive capacity is the maximum output the economy can produce when all resources are fully employed - represented by the position of the LRAS curve

  • Increasing productive capacity shifts LRAS rightward - the economy's potential output rises and the full employment level of national income increases

• This is distinct from a movement along LRAS - supply-side policy shifts the curve itself

Tools of supply-side policy

Education and training

• Investment in education and training raises the human capital of the workforce - the skills, knowledge and productivity of workers

  • Examples include government spending on schools and universities, apprenticeship programmes and subsidised retraining for unemployed workers

• Higher human capital raises labour productivity, reducing unit costs of production and shifting LRAS right

Infrastructure development

• Investment in physical infrastructure - roads, railways, ports, energy networks and digital broadband - reduces the costs of doing business and improves the efficiency of the economy

  • Better transport links reduce delivery times and costs
  • A reliable energy supply reduces production disruptions
  • Fast broadband enables more efficient communication

• Infrastructure investment shifts LRAS right by raising the productive capacity available to all firms in the economy

Support for technological improvement

• Government support for research and development (R&D) - through subsidies, tax incentives or direct public investment - encourages innovation and the adoption of new production technologies

  • New technology raises total factor productivity - more output from the same inputs - shifting LRAS right
  • Examples include government R&D tax credits, university-industry research partnerships and public investment in emerging technologies such as renewable energy and artificial intelligence

Deregulation and competition policy

• Reducing unnecessary regulation lowers costs for firms and encourages new entrants to markets

  • Greater competition incentivises firms to innovate, cut costs and improve efficiency - raising economy-wide productivity
  • Examples include deregulating labour markets to improve flexibility, and removing barriers to entry in key industries

Tax incentives

• Cutting corporation tax raises post-tax profits, increasing the incentive for firms to invest in new capital - shifting LRAS right over time
• Cutting income tax or reducing benefits may increase labour supply by making work more financially rewarding relative to inactivity