In this chapter we take a walk on the supply-side of the economy. The “supply side” refers to factors affecting the quantity or quality of goods and services produced by an economy such as the level of productivity or investment in research and development.

What are supply-side policies?

Supply-side economic policies are mainly micro-economic policies designed to improve the supply-side potential of an economy, make markets and industries operate more efficiently and thereby contribute to a faster rate of growth of real national output

Most governments now accept that an improved supply-side performance is the key to achieving sustained economic growth without a rise in inflation. But supply-side reform on its own is not enough to achieve this growth. There must also be a high enough level of aggregate demand so that the productive capacity of an economy is actually brought into play.

There are two broad approaches to the supply-side. Firstly policies focused on product markets where goods and services are produced and sold to consumers and secondly the labour market – a factor market where labour is bought and sold.

Supply Side Policies for Product Markets

Product markets refer to markets in which all kinds of commodities are traded, for example the market for airline travel; for mobile phones, for new cars; for pharmaceutical products and the markets for financial services such as banking and occupational pensions.

Supply-side policies in product markets are designed to increase competition and efficiency. If the productivity of an industry improves, then it will be able to produce more with a given amount of resources, shifting the LRAS curve to the right.

Privatisation

Over the last twenty-five years, many former state-owned businesses have been privatised – i.e. they have transferred from the public sector into the private sector. Examples in Britain include British Gas, British Telecom, British Airways, British Steel, British Aerospace, the regional water companies, the main electricity generators and distributors, and the Railways.

British Rail was privatised in 1994 but the failure of Railtrack led to the creation of Network Rail, a ‘not for profit’ company in 2002. The Labour Government has continued to privatise or part-privatise other parts of the UK public sector since it came to power in 1997.

Privatization is designed to break up state monopolies and create more competition. The government also created utility regulators who have imposed price controls on many of these industries and who are now over-seeing the move towards competitive markets in areas such as gas and electricity supply and telecommunications.

Deregulation of Markets

De-regulation or liberalisation means the opening up of markets to greater competition. The aim of this is to increase market supply (driving prices down) and widen the range of choice available to consumers. The discipline of competition should also lead to greater cost efficiency from producers – who are keen to hold onto their existing market share. Good examples of deregulation to use include: urban bus transport, parcel delivery services, mortgage lending, telecommunications, and gas and electricity supply.

Toughening up of Competition Policy

Most supply-side economists believe in the dynamic effects of greater competition and that competition forces business to become more efficient in the way in which they use scarce resources. This reduces costs which can be passed down to consumers in the form of lower prices. A tougher competition policy regime includes policies designed to curb anti-competitive practices such as price-fixing cartels and other abuses of a dominant market position – in other words – intervention to curb some of the market failure that can come from monopoly power

A commitment to free international trade

Trade between nations creates competition and should be a catalyst for improvements in costs and lower prices for consumers. The UK government is committed to an expansion of free trade within the European Single Market and also to negotiating a liberalisation of trade in the global economy as part of its membership of the World Trade Organisation. For example, it wants to see further reforms of the Common Agricultural Policy as a stepping-stone to global trade agreements between Europe, the United States and developing countries.

Measures to encourage small business start-ups / entrepreneurship

The small businesses of today can often become the larger businesses of tomorrow, adding to national output, employing more workers and contributing to innovative behaviour that can have positive spill-over effects in other industries. Governments of all political persuasion argue that they want to promote an entrepreneurial culture and to increase the rate of new business start-ups. Supply side policies include loan guarantees for new businesses; regional policy assistance for entrepreneurs in depressed areas of the country; advice for new firms

Capital investment and innovation:

Capital spending by firms adds to aggregate demand (C+I+G+(X-M)) but also has an important effect on long run aggregate supply. Supply side policies would include tax relief on research and development and reductions in the rate of corporation tax. Ireland is a good example of a country inside the EU that has benefited hugely from cutting company taxes which has led to a large rise in foreign direct investment. One of the new countries joining the EU in 2004, Estonia, has cut its corporation tax rate to zero per cent (0%) in a deliberate attempt to attract new investment and stimulate economic growth and employment. There are now big differences in corporation tax rates among the twenty five nations of the European Union.

Corporate Tax Rates in the European Union in 2004
Estonia	0.0%		Luxembourg	30.0%
Ireland	12.5%		Denmark	30.0%
Lithuania	15.0%		Czech Rep.	31.0%
Cyprus	15.0%		Portugal	33.0%
Latvia	19.0%		Austria	34.0%
Slovakia	19.0%		Belgium	34.0%
Poland	19.0%		Italy	34.0%
Hungary	20.0%		Netherlands	34.5%
Slovenia	25.0%		Spain	35.0%
Sweden	28.0%		Greece	35.0%
Finland	29.0%		France	35.4%
UK	30.0%		Germany	38.7%

The issue of incentives is crucial for if inventions and innovations can be widely and easily copied and implemented, then the rewards to those engaged in cutting-edge research might be diluted leading to a decrease in the willingness of entrepreneurs to take risks.

Innovation and Economic Growth

‘A dynamic environment with opportunities for enterprise and innovation is vital to improving economic performance. New businesses entering the marketplace increase competitive pressures facilitating the introduction of new ideas and technologies. The Government is therefore committed to supporting enterprise and innovation throughout the economy, including in Britain’s most disadvantaged areas.’
Source: Government Spending Review Statement, July 2002

Supply side policies for the Labour Market

These policies are designed to improve the quality and quantity of the supply of labour available to the economy. They seek to make the British labour market more flexible so that it is better able to match the labour force to the demands placed upon it by employers in expanding sectors thereby reducing the risk of structural unemployment. An expansion in the UK’s total labour supply increases the productive potential of an economy.  That expansion in the supply of people willing and able to work can come from several sources for example: encouraging older people to stay in the workforce; a relaxed approach to labour migration and measures to get non-working parents to actively look for work.

Trade Union Reforms

Many of the traditional legal protections enjoyed by the trade unions have been taken away – including restrictions on their ability to take industrial action and enter into restrictive practices agreements with employers. The result has been a decrease in strike action in virtually every industry and a significant improvement in industrial relations in the UK.

Increased Spending on Education and Training

Economists disagree about the scale of the likely economic and social returns to be earned from higher spending on education – but few of them deny that “investment in education” has the potential to raise the skills within the work force and improve the employment prospects of thousands of unemployed workers. The economic returns from extra education spending can vary according to the stage of development that a country has achieved.

Government spending on education and training improves workers’ human capital. Economies that have invested heavily in education are those that are well set for the future. Most economists agree, with the move away from industries that required manual skills to those that need mental skills, that investment in education, and the retraining of previously manual workers, is absolutely vital.

It should also be noted that improved training, especially for those who lose their job in an old industry should improve the occupational mobility of workers in the economy. This should help reduce the problem of structural unemployment.  A well-educated workforce acts as a magnet for foreign investment in the economy.

Income Tax Reforms and the Incentive to Work

Economists who support supply-side policies believe that lower rates of income tax provide a short-term boost to demand, and they improve incentives for people to work longer hours or take a new job – because they get to keep a higher percentage of the money they earn.
 
Attention has focused in recent years on lower income households. In the mid 1990s, a lower starting rate of tax of 10% was introduced and the band of income on which this is paid has been widened in recent Budgets. Cutting tax rates for lower paid workers may help to reduce the extent of the ‘unemployment trap’ – where people calculate that they may be no better off from working than if they stay outside the labour force.

Do lower taxes really help to increase the active labour supply in the economy? It seems obvious that lower taxes should boost the incentive to work because tax cuts increase the reward from a job. But some people may choose to work the same number of hours and simply take a rise in their post-tax income! Millions of other workers have little choice over the hours that they work. 

Showing the effects of supply-side improvements in the economy

Supply-side factors often help to explain why it is that some countries grow faster than others. In a world of globalisation, it is becoming clearer that maintaining and improving competitiveness is vital in achieving success in international markets. A rising share of GDP in most countries is devoted to international trade. Markets are becoming more competitive and those countries whose supply-side lets those down can find a rising level of import penetration into their domestic markets and a weak export performance in goods and services.

Supply side improvements can also be shown using a production possibility frontier

Supply side policies and productivity

It is important to recognise that the supply-side does not operate in isolation from changes in aggregate demand. If there is insufficient AD, it is unlikely that better supply-side performance can be achieved over a number of years. Equally, if aggregate demand grows too quickly, acceleration in wage and price inflation might require deflationary policies that ultimately harm a country’s productive potential.

Evaluating the UK’s supply-side performance

Improvements in the Supply Side	Supply-Side Weaknesses
Sustained economic growth. The UK has maintained its position as the 4th largest economy in the world and has weathered the global economic downturn well	There remains a large productivity between the UK and other leading economies – this is now a major focus of supply side policies
There has been a large fall in unemployment and a record level of employment. The UK currently has the highest employment ratio in the EU	Sharp rise in the balance of payments deficit in goods and services – suggesting continued problems of international competitiveness
Falling unemployment and continued low inflation – suggesting an improvement in the trade-off between these two important macroeconomic objectives	Few signs that the underlying rate of economic growth has improved above 2.5% per year – other countries have a faster rate of growth of potential output
	Service sector has been strong but manufacturing industry has suffered three recessions in the last ten years
The UK labour market is seen as one of the most flexible among leading economies, with a rising level of occupational flexibility of labour	Still an investment gap (including under-investment in public sector services such as education, health and transport) and the UK devotes a falling share of GDP to business research and development

 

There is a general consensus that the supply-side of the British economy has improved over the last twenty years even though there are still weaknesses in several sectors and the UK must face up to increasingly fierce competition from other countries as the effects of globalisation take hold. Our product and labour markets are more flexible than they were a decade ago but many businesses complain that government intervention places too heavy a cost of administration and other forms of red-tape and that this acts as a barrier to future investment and growth. Increasing amounts of regulation both from the UK and the European Union can add to business costs and reduce competitiveness.