Supply-side policy
Key terms
Define each term.
Multiple choice
Circle the correct answer.
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?
Against a vertical LRAS curve, an increase in aggregate demand will:
Worked problems
Show your working.
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.
Why productivity growth decides whether pay rises are inflationary. In an economy, average wages rise by 6% over a year while labour productivity rises by 2%. Calculate the approximate growth in unit labour costs and explain the implication for inflation. Then state what would have to happen for a 6% pay rise to be non-inflationary.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How training delivers non-inflationary growth
- A Real output and employment rise while the price level falls, since capacity has grown rather than demand.
- B Growth achieved this way is non-inflationary, which no demand-side policy can deliver.
- C The government funds vocational training, raising the skill level of the workforce.
- D Lower unit costs mean firms are willing to supply more at every price level, so LRAS shifts right.
- E Higher productivity lowers the cost of producing each unit of output for firms.
- F With aggregate demand unchanged, the equilibrium moves along AD to the new LRAS.
- G Better-skilled workers produce more per hour, so labour productivity rises.
Why supply-side policy can resolve a conflict demand policy cannot
- A Unemployment falls and, with unit labour costs contained by productivity growth, the price level eases rather than rises.
- B A government pursues both low unemployment and low inflation.
- C Now instead the government funds training and infrastructure, raising productivity.
- D With capacity unchanged, the labour market tightens and wage growth accelerates beyond productivity growth.
- E Using expansionary demand policy, AD shifts right and unemployment falls below the natural rate.
- F Both objectives improve at once, which is why supply-side policy is described as resolving rather than merely managing the trade-off.
- G LRAS shifts right and the natural rate of unemployment falls, since more of the unemployed are matched to available work.
- H Unit labour costs rise, firms raise prices, and inflation increases, so the two objectives conflict.
Diagrams
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.
Draw an AD/AS diagram with a vertical LRAS. Show a successful supply-side policy shifting LRAS right, and mark the change in real output and the price level. On a second diagram, show an equivalent rightward shift of AD against the same vertical LRAS.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Discuss whether supply-side policies are the most appropriate for reducing unemployment. (13 marks)
Answers
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.
C. Apprenticeships raise the skill of the workforce, so output per worker rises and productive capacity increases. The interest rate cut and the welfare increase both work by raising demand, and a higher unemployment benefit is generally argued to weaken the incentive to take work, so if anything it acts against the supply side.
B. A point inside the curve means resources are unemployed, so raising demand can bring them into use and increase output with no change in capacity. Supply-side policy still shifts the curve outwards, but it does not address the immediate problem, which is that existing capacity is going unused.
B. A vertical LRAS means capacity is fixed in the long run, so extra demand meets a supply that cannot expand and is absorbed entirely by prices. This is the analytical core of the case for supply-side policy: without shifting LRAS, demand management cannot raise long-run output.
Step 1. Calculate productivity before the training. Labour productivity = total output / number of workers = 240 / 8 = 30 units per worker per week.
Step 2. Calculate productivity after the training. 300 / 8 = 37.5 units per worker per week.
Step 3. Calculate the percentage change. Change = 37.5 - 30 = 7.5. Percentage change = (7.5 / 30) x 100 = 25%.
Step 4. Explain why this is a supply-side effect. The workforce has not grown and no extra spending is required to sustain the gain. The same eight workers now produce more, so the firm's costs per unit fall and the economy's productive capacity has risen. That is a change in what can be produced, not in how much is being demanded.
Always divide by the input. Candidates who compare 240 with 300 and report a 25% rise in output have answered a different question, and the fact that the answer happens to be 25% here will not save them when the workforce also changes.
Step 1. Apply the unit labour cost relationship. Growth in unit labour costs = growth in wages - growth in productivity = 6% - 2% = 4%.
Step 2. Check against the exact calculation. Exactly: (1.06 / 1.02) - 1 = 0.0392, or 3.92%. The approximation of 4% is close enough at these rates, which is why Cambridge accepts it.
Step 3. Interpret for inflation. The labour cost of producing each unit has risen by about 4%. Firms facing higher unit costs either accept lower profit margins or raise prices. Across the economy this is cost-push inflationary pressure of roughly 4%, so a 6% pay rise is inflationary even though workers may feel it merely keeps pace with living costs.
Step 4. State the condition for a non-inflationary pay rise. Unit labour costs are flat when wage growth equals productivity growth. A 6% pay rise is non-inflationary only if productivity also grows by 6%. This is the precise sense in which supply-side policy makes higher real wages sustainable: without productivity growth, pay rises are redistributed into prices rather than into living standards.
Step 4 is the analytical payoff and transfers directly into essays on inflation, growth and living standards. A candidate who can say that real wages cannot rise sustainably faster than productivity has a point that applies across half the macro syllabus.
C, G, E, D, F, A, B
- The government funds vocational training, raising the skill level of the workforce.
- Better-skilled workers produce more per hour, so labour productivity rises.
- Higher productivity lowers the cost of producing each unit of output for firms.
- Lower unit costs mean firms are willing to supply more at every price level, so LRAS shifts right.
- With aggregate demand unchanged, the equilibrium moves along AD to the new LRAS.
- Real output and employment rise while the price level falls, since capacity has grown rather than demand.
- Growth achieved this way is non-inflationary, which no demand-side policy can deliver.
The final step is the one worth stating explicitly. Fiscal or monetary expansion raises output at the cost of a higher price level; supply-side expansion raises output and eases the price level. AO2 is 40% of the written papers, and this contrast is where those marks sit.
B, E, D, H, C, G, A, F
- A government pursues both low unemployment and low inflation.
- Using expansionary demand policy, AD shifts right and unemployment falls below the natural rate.
- With capacity unchanged, the labour market tightens and wage growth accelerates beyond productivity growth.
- Unit labour costs rise, firms raise prices, and inflation increases, so the two objectives conflict.
- Now instead the government funds training and infrastructure, raising productivity.
- LRAS shifts right and the natural rate of unemployment falls, since more of the unemployed are matched to available work.
- Unemployment falls and, with unit labour costs contained by productivity growth, the price level eases rather than rises.
- Both objectives improve at once, which is why supply-side policy is described as resolving rather than merely managing the trade-off.
Policy-conflict questions are common in Paper 4 Section C and this chain is the standard resolution. The honest qualification, which belongs in the evaluation rather than the chain, is that the resolution takes years while the conflict is immediate.
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.
Drawing both is the argument. Against a vertical LRAS, a rightward AD shift raises the price level and leaves real output unchanged, which is the purest statement of why demand policy cannot deliver long-run growth. The LRAS shift raises output and lowers the price level. Examiners reward candidates who use the comparison rather than describing one diagram.
Define and frame: Define supply-side policy and unemployment, then immediately separate the types: cyclical or demand-deficient, structural, frictional, and real-wage or classical. State that appropriateness depends on which type dominates, because that single move controls the whole answer and most candidates never make it.
Analysis: the case for: Argue that supply-side policy addresses the causes rather than the symptoms. Training reduces structural unemployment by matching skills to vacancies; improved information and mobility reduce frictional unemployment; benefit and union reforms address real-wage unemployment. Support with an LRAS shift and the falling natural rate, and note that the reduction is permanent rather than requiring continued stimulus.
Analysis: the alternatives: Take demand-side policy seriously rather than dismissing it. Against demand-deficient unemployment in a recession, supply-side policy is close to useless: training the unemployed for vacancies that do not exist changes nothing, and the binding constraint is the absence of demand, not the quality of labour. Fiscal expansion works directly and monetary policy works quickly. Note that at a point inside the PPC the problem is unused capacity, not insufficient capacity.
Evaluation: Weigh rather than list. Time is the central objection: training takes years and infrastructure longer, while an unemployed worker needs income now. Cost and opportunity cost matter, since interventionist measures require spending that competes with other uses and may worsen the deficit. Effectiveness is uncertain, as the post-2008 productivity slowdown shows even determined efforts can fail. Market-based measures have distributional costs, raising employment partly by making low-paid work less well protected. Against all this, weigh the fact that no amount of demand can cure a skills mismatch.
Judgement: Reach a conclusion conditional on stated circumstances. Supply-side policy is the most appropriate response where unemployment is structural or frictional, where the economy is at or near capacity, and where the horizon is long. It is the least appropriate in a demand-deficient recession, where it is slow, and where fiscal policy addresses the binding constraint directly. The defensible position is sequencing rather than choosing: demand policy to close the immediate output gap, supply-side policy to lower the natural rate underneath it. Specify the conditions, because a conclusion that recommends 'a combination' without saying when does not reach the top level.