Economics Department

Supply Side policies - the basics

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Supply side economics came to the fore in the early 1980s, championed by the
governments of Reagan in the US and Thatcher in the UK. Traditional Keynesian
demand management was perceived to have failed to tackle deep structural problem in
developed economies, and as a consequence, markets were less efficient and
productivity lower than it might otherwise have been.

Supply side policies aim to improve the efficiency of factor markets, to boost
productivity and hence the overall capacity of the economy (shifting long run
aggregate supply (LRAS) to the right and pushing out the PPF):

Agg P level AS1 AS2 Consumer goods

P1

P2
AD

Y1 Y2 Real GDP (Y) Capital goods

Broadly these policies aim to increase:

• The quantity
• The quality
• The efficiency of use

Of the four key factors of production (land, labour, capital and entrepreneurial ability)
and thereby foster economic growth.

Broadly policies can be split into three main categories:

1) Fiscal supply side policies
2) Labour market reforms
3) Product market reforms

1) Fiscal supply side policies.

In recent years the government has used fiscal policy to create incentives in both
labour and product markets. It has

• Introduced individual learning accounts offering big discounts to firms and

individuals on training, helping to close the skills/productivity gap with other
countries.
• Extended the welfare to work program, encouraging/coercing the young
unemployed into getting training.
• Guaranteeing a minimum income of £200 per week for working families with a
full time earner and ensuring that no family earning less than £235 a week will
pay any income tax overall (therefore helping to tackle the poverty trap).
• A new 10% bottom tax rate to encourage people to work, increasing the flexibility
of the labour market.

Therefore the tax and spending structure has been used not to alter the level of
demand overall, but to create incentives and opportunities.

Similarly, in product markets, the government has acted to raise both Capital
Investment and R&D spending.:

• The introduction of a research and development tax credit which will reduce the
real cost of R&D, making it more worthwhile.
• A 10p corporation tax band for small firms, to encourage their start-up and to give
more funds for reinvestment
• The creation of a new small business service to support growing firms, and 40%
capital allowances to encourage investment and growth by small firms.

Each of these polices is attempting to improve the overall use of the key factors of
production - boosting the participation rate, increasing investment in both capital
goods and R&D, and increasing the skills base of the workforce. These policies
should hopefully therefore increase the efficiency of UK firms, therefore boosting
productivity, putting downward pressure on prices and increasing international
competitiveness.

2) Labour market reforms

These have occurred mainly in terms of labour market legislation. Over the 80s and
90s, legislation passed has weakened the power of Trade Unions and has increased the
ability of firms to hire and fire, so that UK labour markets are now considered far
more flexible than those on the continent.

Reductions in trade union power have allowed firms to introduce flexible working
more easily, so that workers now work more varied hours, and are more multi-skilled,
putting an end to demarcation disputes. Changes in employment legislation have
meant that firms can take on workers easily and shed them quickly if economic
conditions move against them. This means that UK firms can be more sensitive to
changing market conditions, hence improving international competitiveness.

Over the last 20 years or so legislation has changed so that:

 • Employees can be dismissed without reason within the first year of
employment (except for discrimination cases)
• Unions now have to hold secret ballots of members before industrial action
can be taken, and they have to give notice to employers well in advance of
such action
• Unions are no longer immune to prosecution - if they fail to obey the rules
governing strike action, then unions can have their funds frozen, and be
subject to substantial fines.

3) Product market reforms

The 1970s were characterised by huge state run industries with few incentives to be
efficient. The privatisation and deregulation followed in many developed countries
through the 80s and 90s was a response to this inefficient use of factors of
production. In the UK industries as diverse as car production, coach services, mining
and electricity generation were transferred from government ownership to state
control (in some markets deregulation was the norm, where competition from the
private sector was introduces, but the original firms remained at least partly under
state control).

These former state industries were now exposed to competitive pressures both
domestically and internationally, and were therefore forced to become more efficient.
In the short term there were many job losses as a result of improvements in
productivity (output per worker in the UK steel industry has quadrupled since
privatisation). Therefore the AS curve was shifted out as these employees became
available for work in other sectors of the economy.

Problems with supply side policies

1) Job insecurity - employees now no longer feel safe in their jobs, and stress levels
at work are rising as reduced trade union power has led to the introduction of 'lean'
production techniques which aim to minimise waste.
2) Access to state benefits has been reduced to create incentives to work - hence
unemployed workers face a rougher ride in their attempts to survive the period in
between jobs; income inequality has generally risen over the last 20 years, and
supply side policies have played a part in this.
3) An increase in the capacity of the economy is of no help in itself unless there is a
corresponding increase in AD - in a recession, a focus on supply side reforms may
be at best unhelpful and at worst counter-productive (the early years of
privatisation in the UK saw wide scale job losses from former state-run industries
when the economy was only just recovering from recession. Hence these
unemployed workers found it extremely difficult to find employment. This
worsened the government's finances (due to unemployment benefits) and also led
to deskilling, which increased the level of 'core' unemployment in the economy).

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