2. Supply side policy issues Learning Outcome: To understand the issues of using supply side policy

3. Supply side policies  Supply side policies are government policies designed to increase the productive potential of the economy and push the long run aggregate supply curve to the right  They affect the economy in 4 main ways  May increase the supply both of the quantity and quality of labour  May raise the amount of capital employed or to the introduction of more technologically advanced capital  May lead to further exploitation of natural resources such as oil deposits or agricultural land  May increase the efficiency with which the factors of production are combined

4. Labour productivity and unit labour costs  Supply side policies may affect both labour productivity and unit labour costs  A firm introducing new technology may need less labour and output per worker will increase  If the average wage rates do not change the cost of labour per unit will fall  The firm would now be more competitive  If all firms use the same technology relative competitiveness will remain the same

5. Labour productivity and unit labour costs  As an economy grows productivity will rise  More and more capital will be used by labour to produce goods and services  Workers will become better trained and have more skills  Unit labour costs for the whole economy may stay the same because increases in productivity will be matched by increases in wages  Karl Marx (19 th C) predicted that all the benefit of the increase in labour productivity would go to the owners of capital  History shows this not to have been the case

7. Labour productivity and unit labour costs  Unit labour costs in individual industries and occupations may change over time  If a good or service is not traded internationally and there is a lack of domestic competition labour costs may rise  Labour costs in the NHS and schools have risen substantially over time  When there is a lot of competition unit labour costs tend not to rise as fast  If they get too high the industries become less competitive and production may cease  Falling unit labour costs in the third world led to a decline in the UK textile industry in the second half of the 20 th Century

8. Labour productivity and unit labour costs  There are a variety of supply side policies which can be used to increase labour productivity  Policies that lead to better education and training of workers  Either they become more productive at the same job or are able to do more complex jobs that create higher value products  Policies could include reforming the vocational education system  Tax incentives to firms for spending on training young people  Giving workers training vouchers to spend on training courses  Policies which lead to higher levels of physical investment that will increase the amount of capital per worker  E.g. government grants to firms for investment  Tax incentives to invest  Government loads at below the commercial rate of interest for investment

9. Flexible Labour Markets  If labour markets are highly flexible there will be rapid changes in demand and supply  As a result the natural rate of unemployment will be very low  If labour markets are highly inflexible external shocks will lead to long term disequilibrium  The natural rate of unemployment will be high  There are many ways to classify types of labour market flexibility  One way is to classify according to the strategies that companies use to manage their workforces  External numerical flexibility  Internal numerical flexibility  Functional flexibility Labour market flexibility – the degree to which demand and supply in a labour market respond to external changes such as changes in demand for a product or population changes to return the market to equilibrium

10. Flexible Labour Markets  External numerical flexibility  In a completely flexible labour market firms can hire and fire workers at any time  They can adjust the numbers on a day to day basis  Modern labour markets prevent this  Law gives employment rights  Trade unions threaten industrial action  Some countries make it very difficult to sack permanent workers  This raises the cost of permanent hire and tends to increase numbers of temporary workers  When there is less flexibility less workers will be employed  This may lead to an increase in capital intensity of production

11. Flexible Labour Markets  Internal numerical flexibility  In a completely flexible labour market firms can adjust the number of working hours their staff work to suit their needs  It can change shifts from day to night if necessary  It can cancel holiday leave  In practice firms are restricted in their internal flexibility by both employment law and by workers and their trade unions  Custom and practice means that employees tend to work relatively fixed hours  Firms use a wide variety of schemes to give greater flexibility e.g. overtime

12. Flexible Labour Markets  Functional flexibility  This occurs when a firm can redeploy a worker from one job to another  The workers have to be multi skilled  Traditionally trade unions have resisted functional flexibility because they argue it rates unemployment  Countries where functional flexibility is common are likely to be more competitive  Wage flexibility  Firms that can adjust wages up and down will be more competitive  In practice most workers are on fixed wage contracts  Wage flexibility can be achieved by using bonuses or individual pay bargaining  It is more flexible now in the UK than 30 years ago because there is less union power

13. Flexible Labour Markets  There are many other types of labour market flexibility  Geographical flexibility – willingness of workers to move areas to get jobs  The UK has a relatively high level of mobility compared to the rest of EU  Industrial flexibility – willingness of workers to move from industry to industry  Some argue that flexible labour markets are one of the key reasons why the US and UK economies performed well in the decade prior to the recession compared with some EU countries that have much less flexibility  These countries have more labour laws and union power  Less flexible labour markets do tend to have higher levels of unemployment

14. Incentives at the margin  Tax at the margin is tax paid on every extra £ earned  Neoclassical economists argue that incentives at the margin can significantly change behaviour  Cutting marginal rates on income tax leads to a significant rise in the number of hours worked  It gives an incentive for those not working to get a job  Giving income tax rebates to those who save for a pension encourages people to pay into a pension plan  Cutting unemployment benefits will encourage the unemployed to get a job  The more progressive the tax and benefit system the less incentive individuals have to work  There is a strong economic case to make the tax and benefit system more regressive Marginal tax rate Income earned 20%0-37k 40%37k to 150k 50%150k plus Progressive tax - A tax system in which those who earn higher incomes pay a higher percentage of their income than those with lower incomes Regressive tax - A tax system in which those who earn lower incomes pay a higher percentage of their income

15. Incentives at the margin  Marginal tax rates are not the only influence on employment  Many who currently do not have a job face major obstacles to gaining a job  Single people with young children may have difficulties getting good child care  People that are physically or mentally disabled may find it difficult to find a job which is manageable for their type of disability  The Netherlands and Sweden have better systems to deal with these issues but they are expensive to run

17. Migration  In recent years there has been significant net migration into the UK of people of working age  This increases the potential size of the labour force  When there is an increase in the supply of labour wage rates may fall  If the economy is at full employment this helps inflationary pressures  The exact impact on wages in individual occupations and on economic growth as a whole is more difficult to determine  If all the migrants were plumbers there would be downward pressure on the earnings of plumbers but little impact elsewhere in the economy  Some have said that the UK could benefit from net immigration by targeting particular types of immigrants (highly skilled and highly qualified)

19. Taxation and Investment  The level of taxes on businesses (corporation tax) has an impact on investment and therefore long run AS  An increase reduces firm profitability  Fewer investment projects will be undertaken  Affects both domestic and foreign investment (FDI)  A country can raise inward levels of FDI by lowering taxes  Many argue that the high economic growth in Ireland in the 1980s was due to low business tax

20. Taxation and Investment  Governments place high taxes on business for 3 possible reason  Government spending as a proportion of GDP may be high – the tax finances the spending  If there is higher tax on business the tax on individuals can be lower  In the short term government may be forced to raise tax when in financial difficulty  Free market economists tend to argue that business taxes should be low  It encourages investment and leads to high economic growth  It will encourage FDI  Some argue that tax is only a small part of investment decisions and that levels of business tax are a relatively unimportant in the supply policy mix

21. The contribution of demand side policies  Good economic management of the economy by government which minimises fluctuations in AD has significant supply side benefits for two main reasons  Macro economic stability helps economic agents to make decisions; if the economy is stable there are high levels of investment, more labour mobility and higher consumer spending  When there is low demand in recession it can lead to both physical and human capital being destroyed; equipment is not needed and people become long term unemployed Watch holden video http://www.yout ube.com/watch ?v=v9HEm8w5 nL8

22. Essay Practice  Compare the Effectiveness of Supply side and Fiscal Policies to Correct deficits on a country’s current account of the Balance of Payments (25)  Plan your essay (20 mins)  Think about what the question is asking – which is best supply side or fiscal?  Be prepared to share your plan (or part of your plan) with the rest of the class  Don’t forget to include evaluation points in your plan (don’t wait until the conclusion to evaluate)

23. Essay Practice Define Current account deficit - means the country imports a greater value of goods and services than it exports. To reduce a current account deficit we need to either increase exports and or reduce imports. Supply side policies aim to increase the productivity of the economy. If the manufacturing sector becomes more productive, the relative cost of British goods will fall and therefore they will become more competitive. This will help increase exports and reduce the current account deficit. Always give a couple of examples…. government could increase spending on education and training. –Vocational training schemes may help increase labour productivity because workers will have more skills. –A more productive workforce can improve the competitiveness of UK Exports. Alternatively, the Government could introduce a free market supply side policy such as reducing the power of trades unions. –If unions are powerful, productivity may be lower due to frequent strikes and disruptive working practises such as working to rule. –If union power is reduced it helps reduce time lost to strikes, increases labour market flexibility and therefore should help increase UK exports.

24. Essay Practice Evaluation The problem of supply side policies is that they will take time to have effect. Again give an example spending on education and training may take several years before the effects are noticed. Also, there is no guarantee that education spending may actually increase labour productivity The money may be misspent or the workers may not want to learn. Show UK knowledge In the UK, trades unions are no longer very powerful, so this policy would only have limited impact. Also, some argue trades unions can actually help introduce new working practises and thereby increase productivity.

25. Essay Practice Now look at fiscal Current account deficits often occur during times of economic growth and therefore high consumer spending on imports. Fiscal policy can be used to reduce consumer spending and therefore reduce demand for imports. For example Higher income tax would reduce consumer’s disposable income and therefore reduce imports. UK knowledge In the UK, consumers have a high marginal propensity to import (people spend a high % of extra income on imports), therefore, a reduction in disposable income would have a big impact in reducing import spending. Deflationary fiscal policy would also reduce inflation and help to make UK goods more competitive.

26. Essay Practice Evaluation However, the problem with using fiscal policy is that it will conflict with other macroeconomic objectives Higher taxes will reduce growth and could cause unemployment (explain) Furthermore, unemployment and growth are considered more important than the current account deficit. Also fiscal policy doesn’t address the fundamental underlying problem, which is a lack of competitiveness. This needs to be addressed through supply side policies. Now directly answer the question Deflationary Fiscal policy may be good in a boom when the economy is expanding too fast. However, in the long term supply side policies are best solution to addressing poor competitiveness.