Supply-Side Policies

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    Supply-side policies are designed to increase productivity/efficiency and shift LRAS right. The productive capacity of the economy increases because more can be produced. As LRAS shifts right, the price level falls and real GDP rises.

    The government could make the labour market more flexible to increase the quantity and quality of labour, encourage firms to invest, develop the infrastructure and cut red tape. Many supply-side policies can be used:

    1) Education and Training.

    Education and training improves workers’ human capital. Labour becomes more skilled and efficient, the marginal productivity of labour rises so workers produce more and LRAS shifts right. Also, better trained labour means less structural unemployment as workers can adapt more easily to different jobs, and more employment means more can be produced.

    2) Reduce Income Tax.

    A decrease in income tax is likely to increase labour supply, so the economy can produce more and LRAS shifts right. A lower tax acts through the substitution effect to incentivize workers to work more because they can earn more. A lower tax acts through the income effect to disincentivize workers from working because they can earn the same income as before by working less. As long as the substitution effect is greater than the income effect, a fall in taxes will increase labour supply. Although, if the income effect is greater than the substitution effect, a fall in income tax means a decrease in labour supply, the economy produces less and LRAS shifts left. 3) Reduce Unemployment Benefits.

    Reduce unemployment benefits to encourage the unemployed to work so LRAS shifts right. Although, the unemployed still may not work because wages after taxes may be too low. The government must also decrease taxes at the same time to encourage the unemployed to work.

    4) Remove Minimum Wages.

    Remove minimum wages, wages fall, firms demand more labour so employment rises, more can be produced and LRAS shifts right.

    5) Reduce Trade Union Power.

    Remove (or reduce the power of) trade unions, wages fall so firms demand more labour, employment rises, more can be produced and LRAS shifts right. Also, less strikes occur so workers take less days off work.

    6) Corporation Tax.

    If the government reduce corporation tax, firms’ after-tax profits rise, investment is incentivized because firms keep more of their profits, investment rises, better technology and more efficient machinery is developed, so more output can be produced and LRAS shifts right.

    7) Infrastructure.

    An increase in government spending on the infrastructure means better roads, railways, ports, utility networks and telecommunications, the economy becomes more efficient and firms can produce more so LRAS shifts right.

    8) Research and Development (R&D).

    R&D grants could be used to encourage firms to invest and innovate to develop new and more efficient technology so LRAS shifts right.

    9) Red Tape.

    Red tape could be reduced (for example less laws and form-filling), firms’ costs fall so firms can produce more and LRAS shifts right. Also, more firms can enter the market so competition increases, firms must become more efficient and reduce costs to compete with rivals.

    10) Privatization.

    Privatization is the sale of state-owned assets or enterprises to the private sector. A private frim aims to profit maximize so it is likely to be efficient and minimize costs so LRAS shifts right. Effectiveness of Supply-Side Policies The effectiveness of supply-side policies depends on many factors:

    1) Magnitude.

    A small cut in income tax or a small increase in government spending on the infrastructure will not increase efficiency that much so LRAS only shifts a little bit.

    2) Time Lags.

    Most supply-side policies exert their effect in the long-run. It takes time to educate and train workers, build roads and telecommunication networks and to develop new and more efficient technology.

    3) Short-Run vs. Long-Run.

    In the short-run AD rises because investment is higher, so AD shifts right, spare capacity runs out, the price level rises and real GDP rises. So supply-side policies have inflationary effects in the short-run. Although in the long-run, the price level falls because LRAS shifts right.

    4) Opportunity Cost.

    Supply-side policies may be very expensive so there is an opportunity cost involved. For example, an increase in government spending on the infrastructure may mean less spending on education or healthcare.

     

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