Introduction

In the last few articles, we discussed aggregate demand (“AD”), aggregate supply (“AS”), and how gross domestic product (“GDP”) is determined through an interaction between them and the shape of the long run AS (“LRAS”) curve.

We also discussed demand-side policies, and what governments and central banks can do to control AD and inflation.

If AD intersects LRAS at a point there is plenty of spare capacity, an economy can grow GDP by increasing AD without a disproportionate increase in prices. However, if AD intersects LRAS where an economy is nearing full capacity, an increase in AD may result in a disproportionate increase in prices compared to GDP growth. At this stage, economies may need to lower AD.

Further, to sustainably grow GDP, they may need to focus on supply-side policies.

In the next few articles, we discuss supply-side policies – both interventionist and market oriented.

A point to note, however, is that governments will likely be using a mixture of demand side policies and supply side policies at the same time to encourage economic growth, and likely won’t wait until an economy is near full capacity to focus on supply-side policies.

Increasing aggregate supply

As discussed in the articles on AS, AS is an aggregate of the factors of production within an economy i.e. land, labour, capital, and entrepreneurship. Take a look at our article on the introduction to AS to remind yourself of what these are.

An economy can increase AS through increasing the quantity (thereby reducing the price/cost) or quality of the factors of production, and a government can adopt policies aimed at doing this.

Types of supply side policy

Supply side policies are generally categorised as either:

1. Market oriented; or
2. Interventionist.

Laissez-faire (let it be) economists (and often the political right) advocate for market-oriented policies, and against interventionist policies. This is because market-oriented policies are aimed at removing the barriers to a perfect market and improving market incentives, and laissez faire economists think that a perfect market is the best way to achieve productive and allocative efficiency.

Further, interventionist policies involve governments getting directly involved in a market. Laissez faire economists think that this may distort the free market, thereby reducing its efficiency. In addition, governments may not make the most efficient use of public money for various reasons, including:

1. The lack of a profit motive – the government isn’t trying to make money, and therefore the incentive to be efficient is reduced; and
2. The lack of expertise and resources within the government (including funds to pay for the best talent).

However, free markets don’t always result in perfect markets. A perfect market is just an economic model which has a number of assumptions, including that good and services are homogenous (the same) and interchangeable, the ability of participants to enter and exit the market freely, perfect information for both buyers and sellers, and no wrongdoing within the market (e.g. price collusion, mis-selling, fraud etc).

In reality, however, perfect markets don’t exist for various reasons. For example, goods and services differ, there are barriers to entry, there is imperfect information between buyers and sellers, and there will always be actors in the market that do wrong. Further, free markets may result in negative externalities – negative side effects from allowing markets to operate without intervention (such as pollution, contamination, customers acquiring products they don’t understand etc).

Considering this, some economists advocate for interventionist policies where the free market is not achieving the desired outcomes, or to combat negative externalities. For example, in the sale of complex financial products to retail investors, those investors might not understand or have perfect information in relation to the products, which could result in mis-selling and unfair outcomes. Accordingly, financial regulation might impose requirements on what information must be given, amongst other things. This is an example of an interventionist policy (albeit not a supply-side interventionist policy, which we discuss in the next article).

When we discuss supply-side policies below, bear in mind that these may also have demand-side effects.

Market-oriented supply side policies

As stated above, these are aimed at removing the barriers to a perfect market and improving market incentives.

We set out several examples below.

Tax cuts on employment

If taxes on employment are cut, more people within an economy might be willing to work, thereby increasing the quantity of labour.

Another effect is that people will get more money for each additional hour worked, so may be more willing to work longer hours, also increasing the quantity of labour. This is known as the substitution effect.

However, there is a countervailing factor known as the income effect. If people have more money, they may be happier to work less, thereby reducing the overall quantity of labour.

Governments need to assess these factors carefully prior to making decisions on tax cuts.

Further, governments must also consider the loss of income from tax cuts, and how this reduction will be filled. Will there be tax rises elsewhere? What are the effects of this? If not, will the government be able to fund its spending plans? Will it have to borrow more money? What impact will this have on overall government finances?

Finally, tax cuts might also have demand-side effects; if people have more money, they may spend this in the market, thereby increasing AD.

Tax cuts for businesses

If taxes are cut for businesses, they will have more profits that they can use for investment purposes. This investment could be used to increase capital stock (such as factories, premises etc), thereby increasing both quantity and quality (if new stock is more efficient) of factors of production.

Alternatively, businesses may choose to invest in research and development, which may increase the quality of the factors of production.

Again, governments will need to consider the wider impact of tax cuts, including how they will be funded etc.

An example of a recent tax break for businesses that was introduced during the Covid-19 pandemic, and which has just been made permanent, is the ability for businesses to deduct the full cost of investing in machinery and equipment from their tax bill.

As above, such tax cuts can also have demand-side effect; investment (spending on capital assets by businesses) is a component of AD, and an increase in investment spending will increase AD.

Deregulation of labour markets

Governments can deregulate labour markets in various ways which may boost AS, including:

Reducing or removing the minimum wage – laissez faire economists believe that a minimum wage may increase wage levels beyond the true equilibrium point. They argue that this causes unemployment because, at this higher wage, firms do not demand / cannot employ as many workers as they would at the lower, true equilibrium wage.

Accordingly, laissez faire economists think that removing or reducing the minimum wage will remove this upward pressure on wages, bring them down to equilibrium levels, and increase employment – thereby increasing the quantity of labour that firms can employ.

Further, firms will have more profit (because they are paying less to workers), which they can reinvest into the business – thereby increasing the quantity or quality of other factors of production (depending on what they invest in).

The alternative argument, however, is that a minimum wage may bring wages closer to a true equilibrium wage; certain employers might be in an overly dominant position and can abuse this to bring down wages to below the true equilibrium level, but the minimum wage counteracts this.

Further, firms might not reinvest any additional profits, and instead owners could take these for themselves.

In addition, lower wages could cause people to leave the labour force (i.e. they do not look for work at current wage levels) because the incentive to work may not be sufficient to warrant sacrificing their free time, and they may be better off on welfare payments.

Finally, a reduction in wages will also have demand-side effects because workers will have less to spend. However, this may be offset by the increased number of workers employed, and the overall reduction in prices due to cheaper labour.

As you can see, any decisions in this area will be complex, can be difficult to model, and changes to policy may cause unexpected results. For example, when the minimum wage was introduced in the UK in 1999, many economists thought that this would cause significant unemployment by pushing wages above the true equilibrium level. However, this did not happen, and the minimum wage appears to have had a positive impact, including on reducing inequality at the lower wage levels, particularly amongst women, young people, and people in the low-wage regions in the UK.

Further detail about this can be found at the following link (it’s a short article, and well worth the read). Query, however, whether this made the UK less competitive on the international stage for industries such as manufacturing, of which a large part is now taken in countries with low labour costs.

Making it easier to hire and fire workers and reduce pay – this can be done by relaxing laws on redundancy payments, unfair and constructive dismissal, mandatory pension payments etc.

If it is easier and cheaper to hire and fire, this may encourage firms to hire more workers, thereby increasing the quantity of labour employed.

Further, as discussed in our article on Keynesian Aggregate Supply, wages are sticky downwards, meaning they cannot fall to the true equilibrium level following a reduction in demand due to legal and social pressures. This may cause unemployment i.e. a reduction in the quantity of labour employed.

By removing some of the legal obstacles to hiring and firing workers and reducing pay, firms may be able to lower wages (sometimes under the threat of dismissal) according to demand. This may result in firms not needing to make as many people unemployed even if there is a drop in demand.

Introduce flexible working contracts – such as zero hours contracts, which allow firms to call employees only when required, and in relation to which employment rights are reduced. This allows firms to respond to demand, which may result in increased employment overall i.e. increased quantity of labour employed.

Reducing the power of trade unions

Trade unions collectively bargain with employers on behalf of employees. They also can organise strikes and campaign politically, and may hold a large amount of political power by publicly supporting a particular party (which means they can make certain demands for their members).

Laissez faire economists argue that this distorts the labour market and pushes real wages up beyond the true equilibrium point. For the same reasons discussed above in relation to the minimum wage, laissez faire economists think that this causes unemployment. Accordingly, disempowering trade unions may increase the quantity of labour employed, and increase firms’ profits which they can reinvest.

However, note the counter arguments also discussed above, including that (1) firms may not reinvest profits, (2) without trade unions some firms may be in a dominant position which they can abuse to push wages below equilibrium, and (3) a reduction in wages may have a negative impact on the total number of people willing to work and AD.

Reducing welfare payments, or enhancing eligibility conditions

Welfare payments include unemployment benefits, disability payments, child benefits, amongst others.

Reducing such payments, or enhancing eligibility conditions, may make work more attractive in comparison to receiving welfare, and may force more people into the labour force – thereby increasing the quantity of labour.

However, if there are not enough jobs for the increased labour force, this may not have as significant an impact. This policy may be more impactful when an economy is operating at close to full capacity and there is a shortage of labour.

Reducing or removing the barriers to international trade, overseas capital, and foreign labour

Barriers to international trade could include, for example, tariffs or taxes. They can also include other non-tariff barriers, such as domestic regulation in relation to certain goods.

If barriers to international trade are reduced (i.e. goods coming in), this may result in increased import demand.

This could cause firms to invest in an economy, thereby increasing the quality or quantities of the factors of production (depending on what they invest in – e.g. land, capital stock such as machinery, research and development etc). This may also have demand-side effects.

If barriers to overseas capital are removed, international parties may more willing or able to invest in an economy. This could increase the quality or quantities of factors of production (depending on what they invest in).

If barriers to foreign labour are removed, this may increase the quantity of labour.

However, there are significant complexities in allowing the freedom of international trade, overseas capital, and foreign labour. In return for reducing barriers, countries will usually want to ensure that their goods, services, capital and labour can freely enter other jurisdictions. Accordingly, they will likely not reduce barriers unilaterally. Instead, countries may endeavour to strike a trade deal with other countries which contains various conditions. As seen in relation to Brexit, this can prove very difficult due to competing interests between trading nations.

Further, having a freer international market may make the national market less attractive. This could reduce investment within a country, resulting in a reduced AS. Further, workers may consider it more attractive to work abroad, resulting in a reduced quantity of labour domestically, and therefore reduced AS. There may also be a negative impact on AD if consumers prefer to spend money on imports.

In relation to reducing barriers to international capital, this raises questions of where a country is happy to accept money from. For example, would a country want to accept money from certain countries where there is a higher risk of money deriving from criminal activities? Or from countries with a poor human rights record? There is also the question of how much of a nation’s assets a government is comfortable being in the hands of foreign owners, and whether this impacts national interests and security.

Finally, in relation to reducing barriers to international labour, a country will need to asses the impact of the growth on labour supply and AS, versus the increased population, what this means for GDP per capita, and distribution of resources – will citizens be worse of in real terms? There will also be a wider range of social considerations at play.

As you can see, reducing barriers to international trade, capital, and labour can be complex, and governments will need to consider all factors carefully.

Deregulation

Regulation and red tape can act as a barrier to supply, and an additional cost to production. Accordingly, if markets are deregulated, firms may be able to produce goods and services more easily and cheaply, resulting in increased AS.

However, regulation may often be imposed to mitigate negative externalities (side effects) or imperfections within the free market (which may not be perfect markets). For example, by regulating the ways in which homes must be build, countries may set a minimum standard for housing stock. Laissez faire economists might argue that the market will ensure standards are met, or at least that lower quality will be reflected in price. However, this assumes the buyer has perfect information and can assess the property being purchased, which may not be the case. Further, the range of standards that buyers might accept in the market (especially one in which there is a shortage) may be lower than a government deems suitable (with the benefit greater information and a longer term view).

This is but one example, and countries need to carefully consider the impact of deregulation (and, indeed, new regulation). Such matters are often the subject of detailed analysis and consultation with stakeholders.

Conclusion

You should now have a broad understanding of what supply-side policies are in general, along with a greater understanding of market oriented supply-side policies.

In summary:

• Where an economy is operating close to full capacity, GDP growth might only be achievable through growing AS. This can be done by using supply-side policies;
• A country can grow AS through increasing the quantity (which decreases prices) or quality of factors of production (land, labour, capital and entrepreneurship);
• Supply-side policies are often split into market-oriented supply-side policies, and interventionist supply-side policies. Economists argue over the effectiveness of the different types of policy;
• Market oriented supply-side policies focus on removing the barriers to a perfect market and improving market incentives. Interventionist policies involve governments getting directly involved in a market;
• Examples of market oriented supply-side policies include (amongst others):
  • Tax cuts on employment;
  • Tax cuts on businesses;
  • Deregulation of labour markets;
  • Reducing the power of trade unions;
  • Reducing welfare payments, or enhancing eligibility conditions (thereby making it more attractive to work);
  • Reducing or removing the barriers to international trade, overseas capital, and foreign labour;
  • Deregulation generally;

• Such policies involve multiple competing and complex considerations, and governments must carefully analyse and consult stakeholders prior to taking policy decisions.