Fiscal and monetary policy both work by changing how much people spend. Neither changes what an economy is actually capable of producing. A country can stimulate demand all it likes, but if its workers are poorly trained, its roads are congested and its firms face no competition, the extra spending mostly turns into higher prices. Supply-side policy is the attempt to raise the ceiling rather than push harder against it, and it is the only kind of policy that can do so.
Supply-side policy
Government measures intended to increase the productive capacity of the economy by improving the quantity or quality of the factors of production, or the efficiency with which they are used.
The word that earns the mark is capacity, or potential output. A definition built around 'increasing supply' is too vague, because a fall in the price of oil increases supply and is not a policy. Say that it raises what the economy is able to produce, and the distinction from demand-side policy is made in the first sentence.
The measures
Supply-side measures fall into a few recognisable families. Education and training raise the skill of the workforce, so each worker produces more. Investment in infrastructure, meaning transport, energy and communications, lowers costs for every firm that uses it. Cutting income tax is intended to strengthen the incentive to work, and cutting corporation tax the incentive to invest. Labour market reforms such as reducing trade union power, lowering unemployment benefits or relaxing employment protection are meant to make wages and hiring more flexible. Privatisation transfers firms from state to private ownership on the argument that the profit motive drives efficiency. Deregulation and competition policy remove barriers to entry so that incumbent firms face pressure to improve.
Notice that these measures point in very different political directions, which is worth seeing early. Spending on schools and railways requires a larger and more active government. Cutting benefits and deregulating requires a smaller and less active one. Both are supply-side policy, because both are aimed at productive capacity rather than at demand. A question asking you to evaluate supply-side policy is rarely asking about the whole family at once, so identify which measure is actually in front of you.
The classic error is treating any government spending as supply-side because it is a policy. Building a hospital raises aggregate demand immediately, like any spending, and raises capacity years later by producing a healthier workforce. Both effects are real. Say which one you are analysing, because an answer that slides between them without noticing is the one that loses marks.
Labour productivity = total output / number of workers (or output per worker per hour)Productivity is output per unit of input, not total output. A firm that doubles output by doubling its workforce has not become more productive. Formulae are not printed in any 9708 paper, so recall it.
Measuring the effect of a training programme
A factory employs 8 workers who together produce 240 units a week. After a government-funded training scheme, the same 8 workers produce 300 units a week. Calculate labour productivity before and after, and the percentage change.
Draw a production possibility curve for an economy producing capital goods and consumer goods. Show the effect of a successful supply-side policy. Then, on the same diagram, mark a point inside the curve and show what a successful demand-side policy would do from there.
This is the cleanest way to see the difference. Supply-side policy shifts the whole curve outwards, raising what is possible. Demand-side policy moves the economy from a point inside the curve towards it, using capacity that already exists. An economy already on its curve can only grow by shifting it.
Which of the following is a supply-side policy?
An economy is producing at a point inside its production possibility curve. Which statement is correct?