<3.7: SUPPLY-SIDE POLICY>

RATIONALE: Previously we learned that EDUCATION & HEALTHCARE, create POSITIVE EXTERNALITIES OF CONSUMPTION, however, if left to the free market, the EXTERNAL BENEFITS of a HEALTHY and EDUCATED WORKFORCE in terms of increases in productive potential via a LARGER and more PRODUCTIVE LABOUR FORCE will NOT be INTERNALISED, as firms will only factor in private costs and benefits and as a result UNDER PROVIDE these services. Therefore the government intervenes by providing the following:

EDUCATION & TRAINING

• • Directly provide free training courses to make structurally unemployed workers more employable by equipping them with the skills currently demanded. 

  • Assisting young people to pursue training through study grants or low-interest student loans.

  • Direct government hiring. 

  • Provision of on-the-job training.

  • Providing grants to firms that offer on-the-job training; 

  • Offering subsidies to firms that hire structurally unemployed workers.

  • Assisting workers to relocate to geographical areas where there is a greater demand for labour through grants and subsidies (such as the provision of low-cost housing); 

  • Providing information on job availability in various geographical areas; 

  • Establishing government projects in the depressed areas that result in new employment creation.

ACCESS TO IMPROVED HEALTH CARE SERVICES

• Free healthcare services

• Free Hospital admissions

• Free Dental services

• Subsidised eyewear

. . . . .

RATIONALE: Previously we learned that R & D, create POSITIVE EXTERNALITIES OF PRODUCTION, in particular, the development of new technologies, which results in greater productivity and cost savings for 3rd parties which is a major contributor to increases in potential output and economic growth, however, it is VERY EXPENSIVE and the RISK versus RETURN is uncertain and therefore it is underprovided in the free market, in addition, the actual  focus of the research may not be the most impactful in terms of the external benefits created, therefore the government can intervene to encourage the development of specific technologies in the following ways:

• Provide incentives to private sector firms to engage in R&D activities; these usually take the form of TAX INCENTIVES, as well as the GRANTING OF PATENTS for the protection of inventions. 

• DIRECT GOVERNMENT SPENDING in support of new technology development leads to increases in aggregate demand over the short term and increases in potential output over the longer-term shifting the LRAS or Keynesian AS curves to the right.

RATIONALE: INFRASTRUCTURE is a type of physical capital, which includes power, telecommunications, roads, dams, urban transport, ports airports, irrigation systems, etc. More and better infrastructure increases efficiencies in production as it SAVES TIME and LOWERS COSTS leading to greater productivity and output In other words it creates EXTERNAL BENEFITS for society in the form of EXTERNAL ECONOMIES OF SCALE. However, due to the nature of these products the free market will either under-provide them (In the case of merit goods) or not at all (in the case of public goods). Therefore the government intervenes to correct this POSITIVE EXTERNALITY OF PRODUCTION in the following ways:

• Direct provision

• 'Contracting out' to private sector firms

• RATIONALE: We will learn in later units that in most cases the industries in developing economies are still heavily concentrated around their specific primary factor endowments, we will also learn that this is highly problematic and seriously hinders their ability to achieve future economic growth through exports. 

• Furthermore, developed economies have huge cost advantages in terms of 'economies or scale' which make it extremely difficult for developing nations to compete hence, In order to allow for diversification into more lucrative industries, the government needs to not only encourage local entrepreneurs to delve into these markets but also afford them a level of protection from already established international brands with huge cost advantages. In order to achieve this governments can use the following tools.

• SUPPORT FOR SMALL & MEDIUM-SIZED ENTERPRISES (SMEs): Governments can provide support to small and medium-sized firms, which may take the form of tax exemptions, grants, low-interest loans and business guidance. This provides support for the private sector, promoting efficiency, more capital formation, more employment possibilities and therefore increases aggregate demand as well as potential output.

• SUPPORT FOR 'INFANT INDUSTRIES': ‘Infant industries’ are newly emerging industries in developing countries, which sometimes receive government support in the form of grants, subsidies, tax exemptions, and tariffs or other forms of protection against exports. This also provides support for growth of the private sector and increases in aggregate demand and growth in potential output.

• RATIONALE: GREATER COMPETITION among firms forces them to REDUCE COSTS, contributing to GREATER EFFICIENCY in production and improving the allocation of resources, with the possible added benefit of BETTER QUALITY of goods and services. These benefits amount to RELEASING UNPRODUCTIVE RESOURCES and PUTTING THEM TO USE IN MORE SUITABLE AND PRODUCTIVE ACTIVITIES, thus allowing potential output to increase and the LRAS curve to shift to the right.

  • • PRIVATISATION: Privatisation, involving a transfer of ownership of a firm from the public to the private sector, can increase efficiency due to improved management and operation of the privatised firm. This is based on the argument that government enterprises are often inefficient as they have bureaucratic procedures, high administrative costs and unproductive workers, because they do not face incentives to lower costs and maximise profits. The private sector may therefore be more efficient than the public sector.

    • DEREGULATION: Deregulation involves the ELIMINATION or REDUCTION of GOVERNMENT REGULATION of PRIVATE SECTOR ACTIVITIES, and is based on the argument that government regulation stifles competition and increases inefficiency. 

      • • • ‘ELIMINATE ECONOMIC REGULATION’ involves government control of prices, output, and other activities of firms, offering them protection against competition. In the last two to three decades, many countries have moved toward removal of government regulations, and hence economic deregulation. A main form of deregulation has been to allow new, private firms to enter into monopolistic or oligopolistic industries, thus forcing existing firms to face competition. The objective has been to increase efficiency, lower costs and improve quality. Industries affected include transport, airlines, television broadcasting, telecommunications, natural gas, electricity, financial services, and others.

          • ‘ELIMINATE SOCIAL REGULATION’ involves protecting consumers against undesirable effects of private sector activities (many of these involve negative externalities) in numerous areas, including food, pharmaceutical, and other product safety, worker protection against injuries, and pollution control. In contrast to economic regulation, social regulation is being strengthened in many countries in the interests of public safety. Some economists, however, argue that social regulation is excessive, giving rise to costly and inefficient bureaucratic procedures, paperwork, and unnecessary government interference, and should therefore be reduced.

• Private financing of public sector projects. Historically, public sector projects (such as building roads, harbours, airports, schools, hospitals and other infrastructure) have been financed out of the government budget (tax revenues). In more recent years, a number of countries have introduced private financing of public projects, called private financing initiatives, where a private firm builds, finances and operates public services. The capital and services are owned by the private company, and the government buys the services from the private firm. Such initiatives increase competition, because private sector firms compete with each other to be selected by the government to take on the project; the government selects the private firm that offers to build and run the service at the lowest cost and provide the best quality.

• CONTRACTING OUT GOV'T PROJECTS (OUTSOURCING) Here, public services are provided by private firms based on a contractual agreement between the government and the private service provider. Examples include information technology, human resources management, and accounting services. These result in increased competition as private firms compete with each other to get contracts with the government, thereby resulting in improved efficiency, lower costs of production, and improved quality.

• RESTRICTING MONOPOLY POWER: Increased competition can result from restricting the monopoly power of firms by enforcing anti-monopoly legislation, by breaking up large firms that have been found to engage in monopolistic practices into smaller units that will behave more competitively, and by preventing mergers between firms that might result in too much monopoly power. Greater scope for the forces of supply and demand may result in increased efficiency, lower costs and improved quality.

• TRADE LIBERALISATION: International trade between countries has become freer in recent decades due to reductions in trade barriers. This topic will become clearer after you read Chapter 14, where you will discover that according to economic theory, free or freer trade increases competition between firms both domestically and globally, resulting in greater efficiency in production and an improved allocation of resources. 

One of the MAJOR causes of STRUCTURAL UNEMPLOYMENT is LABOUR MARKET RIGIDITIES which are factors preventing the free market forces of supply and demand for labour operating.  

• ABOLISH MINIMUM WAGES as when this is set above equilibrium it reduces the quantity of low skilled labour demanded by firms as their costs of production rise.

• ABOLISH TRADE UNION POWER as union power and the threat of industrial action often prevents wages from falling regardless of market forces, again creating a reduction in the quantity of low-skilled labour demanded if the wage is above equilibrium.

• LOWER UNEMPLOYMENT BENEFITS in order to increase the incentive to find a job, so people won't remain frictionally unemployed (Unemployed and technically 'looking for work) for extended periods of time.

• REDUCE EMPLOYMENT PROTECTION and make it easier for firm's to HIRE & FIRE workers. Labour laws make it costly for firms to fire workers (because they must pay compensation), thus making firms more cautious about hiring. Hence reducing workers’ job security by making it easier and less costly for firms to let go workers has the effect of increasing employment, because firms are more likely to hire new workers if they know they can fire them easily and without cost if they are no longer needed. In addition, reducing job security would decrease firms’ labour costs because of the lower costs of firing, and would therefore increase profits, investment and growth. See 'FLEXICURITY' in Denmark

INCENTIVE-RELATED POLICIES involve CUTTING various types of TAXES, which are expected to change the incentives faced by taxpayers, whether firms or consumers.

• LOWERING PERSONAL INCOME TAXES: Cuts in personal income taxes lead to higher after-tax incomes, creating an incentive for people to provide more work: this can happen through an increase in the number of hours worked per week; an increase in the number of people interested in finding work (who were formerly not interested in working); an increase in the number of years worked, as people may decide to retire later; a decrease in unemployment as unemployed workers choose to shorten the duration of their unemployment. All these factors may work to shift the LRAS curve to the right, increasing potential output.

• LOWERING TAXES ON CAPITAL AND INTEREST GAINS: In many countries, people must pay taxes on ‘CAPITAL GAINS’, which are profits from financial investments (such as stocks and bonds) or from buying and selling real estate. In addition, they may have to pay taxes on income from interest on savings deposits. If the taxes they must pay on these sources of income are reduced, they may be more motivated to save, thus increasing the amount of savings available for investment. More investment means a greater production of capital goods and an increase in potential output.

• LOWERING BUSINESS TAXES: Lower taxes on business profits can work to increase aggregate demand by increasing investment spending. Supply-side economists argue that cutting taxes on firms’ profits is a supply-side measure because increases in the level of after-tax profits mean that firms have greater financial resources for investment and for pursuing technological innovations through more R&D. Both these effects give rise to greater potential output.

VERDICT = YES!

• Any investment in HUMAN CAPITAL should lead to a direct fall in the level of unemployment. because education and retraining programmes should INCREASE THE OCCUPATIONAL MOBILITY OF LABOUR and reduce structural unemployment. 

• Investment in INFRASTRUCTURE including better transportation and internet networks should INCREASE THE GEOGRAPHICAL MOBILITY OF LABOUR by not only making it easier for people to find work via internet searches but also by enabling workers in remote areas to travel farther distances to work, which should lower structural and frictional unemployment. 

• INVESTMENT IN NEW TECH, INFRASTRUCTURE & OTHER INDUSTRIAL POLICIES, are all intended to lower costs and/or increase output, which should as a result create a derived demand for labour and lower unemployment.

VERDICT = YES!

Labour market reforms are solely intended to reduce the amount of structurally employed and in turn reduce the natural rate of unemployment.

VERDICT = NO!

• Greater levels of COMPETITION, both domestically and from abroad (from TRADE LIBERALISATION) will inevitably lead to less efficient and high-cost firms exiting the market, which will LIKELY CREATE UNEMPLOYMENT in the short term. 

• When firms are PRIVATISED, they try to make their operations more efficient as they now have a strong profit motive and this cost-cutting can involve REDUNDANCIES.

• If the government CONTRACTS OUT to the private sector and chooses a foreign producers instead of domestic then  unemployment will rise.

VERDICT = YES!

• Supply-side policies, whether interventionist or market-based, are likely to REDUCE INFLATIONARY PRESSURE OVER THE LONG TERM. The reason is that these policies are intended to increase potential output, shifting the LRAS curve to the right. As an economy grows, if increases in aggregate demand are matched by increases in aggregate supply, there will be little or no upward pressure on the price level. The ability of supply-side policies to reduce inflationary pressures can also be understood in terms of the focus on keeping firms’ costs of production down through increases in efficiency (due to increased competition) and lower wage costs (due to increased labour market flexibility).

• If supply-side policies are successful at shifting the LRAS to the right, and lowering the rate of inflation/the price level, then exports should become relatively cheaper and more competitive.

VERDICT = YES!

Interventionist policies that focus on investments in human capital that are broadly distributed throughout the population are likely to have positive effects on equity over the longer term. The reason is that educated, skilled and healthy workers are more likely to be employed and be an active and productive part of society, with the result that income is likely to be relatively more equally distributed. In addition, interventionist policies that lower the natural rate of unemployment reduce inequality by providing incomes to previously unemployed workers.

--VERDICT = NO!--

Market-based policies tend to have negative effects on equity. Greater competition may have a negative effect if it results in some unemployment, which involves a loss of income. Labour market reforms involve changes in legislation and institutions that provide protection for workers with very low incomes and with income uncertainties (minimum wage legislation, protection against being fired, unemployment benefits). Reducing protection results in lower incomes for some workers and increased job insecurity, and contributes to increasing income inequalities. 

--VERDICT = NO!--

The argument that high taxes create disincentives to work and save mainly applies to higher income groups who face higher average tax rates; therefore, tax cuts will mostly impact the after-tax incomes of higher-income groups making the system less progressive, thus reducing the redistributive effects of personal income taxes and making income distribution less equal. In addition, since it is the wealthy who enjoy capital gains and earn most of the interest income and business profits, tax cuts in these areas will affect wealthy people by increasing their after-tax incomes more than they will affect lower-income groups of the population.

--VERDICT = NO!--

If PRIVATISATION results in a large amount of market power (Price-setting ability) held by a SINGLE FIRM then this monopoly power may result in reduced output and higher prices, making the product less affordable to low-income groups and if the product is a necessity or a merit good, then it will result in less consumption and WORSEN EQUITY.

Given that supply-side policies are aimed at increasing potential output levels in the economy, It may have negative effects on the environment because of the increased scope for activities leading to negative externalities affecting the environment.