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Supply Policy

RESOURCE: Supply Policy

Supply-side policies

Have you ever asked yourself why products such as Angry Birds, Skype, Spotify, Linux, Nokia and (Sony) Ericsson mobile phones all come from two such small countries as Finland and Sweden? A major explanation has to do with the access to information technology. Sweden and Finland have the highest number of computers per capita, and also the highest access to high-speed internet connections! In addition, the level of education is generally high and the political climate is stable. That is, the countries provide a great basis for innovation of new products and growth of companies. This is something that all countries seek to achieve by the use of supply-side policies.

Supply-side policies and the economy

Rather than attempting to affect the quantity of goods and services demanded in an economy, supply-side policies seek to affect production. That is, they seek to increase the potential output by firms in the economy. This can be done by either facilitating the institutional framework for companies, making it easier to found and administer firms, or by improving the capacity to produce. The latter is done by improving the quantity and/or quality of the factors of production.

Supply-side policies can be either interventionist or market-based. The former involves the government intervening in the market to actively improve the factors of production while the latter is concerned with maximising the ability of market forces to operate freely without excessive bureaucracy and excessive state meddling in company administration. Regardless of the way in which they seek to achieve it however, the primary objective of all supply-side policies is to shift the LRAS-curve to the right, thereby achieving growth in potential national output.

Interventionist supply-side policies

There are numerous things the government can and should do in order to improve the quantity and quality of the factors of production. The examples provided below are in no way the exhaustive, but they are the policies that the IB syllabus requires you to know about.

Investment in human capital

Human capital has to do with the labour factor of production. Investments in education and training of workers will improve the quality of human capital and thereby allow firms to produce more. The government provides both the primary schooling necessary in any modern society (teaching children how to read, write and count) and higher education, allowing students to specialise in a certain field via university education.


A student who studies to become a doctor is, after he or she has finished studying, able to produce medical services. This was not possible before and, as such, the potential output in the economy has increased thanks to the fact that the government ensures that there is medical education. While investment in such education shifts the AD to the right in the short run (via wages for lecturers and all the supplies needed during the education) the effect of shifting the LRAS-curve to the right will be much more significant.

Obviously, government investment in education to improve the labour factor of the production is associated with a time-lag in the sense that the costs are immediate while the benefits lie, often far-away, in the future. The gains from good education are however unquestionable and hence why it is regarded as essential all over the world.

Investment in new technology

By encouraging research and development, the government can improve the capital factor of production. Remember that capital refers to produced goods that are used in the production of other goods and services, such as a pen, a computer or a printing press. While much research and development is undertaken by the firms themselves, the government can contribute by offering research scholarships or undertaking its own projects. For example, the technology invented by NASA to make space travel possible is now used in many different fields. Again, investment in technology will have a short-term positive effect on AD but, in the long run, the shift in aggregate supply will play a more major role.

economics3  Supply Policy economics3

Investment in infrastructure

Investment in infrastructure is the most straightforward way of improving the land factor of production. Access to a particular piece of land by road or railroad greatly improves the value of the land and makes sure that production can take place. Before deciding to invest and increase production, firms will seek to ensure that they’re able to get the products produced from the factory and to consumers, and this will certainly not be possible without good infrastructure. In addition to roads, railroads, harbours and airports, internet connection is becoming an important part of the infrastructure in any country.

Industrial policies

The government can target specific areas of the economy in order to promote desirable growth. For example, it is easy to imagine the government subsidising research in certain pharmaceuticals or subsidizing the establishment of small, technology-intensive companies. In fact, the government may even seek to influence where a company should be situated by offering reduced tax in areas with high unemployment and thus spare factors of production. Again, the use of fiscal policy will certainly have immediate effects on aggregate demand, while the supply-side effects will only be visible after some time. They may however have a significant positive impact on the economy.

Market-based supply-side policies

As explained above, market-based policies are aimed at enabling the market to operate without constraints. In many cases, this involves minimising government intervention, even if this does not hold true for all market-based policies. Indeed, government intervention is sometimes necessary to allow the market to operate freely. Again, the policies discussed below are merely the ones that the IB requires you to know about. There are numerous other supply-side policies that you may include under this heading.

Policies to encourage competition

Free competition is essential in any market system. Because it is assumed that efficiency is maximised when firms are motivated by the opportunity of making a profit, deregulation and privatization of previously state-controlled markets is often a step in the right direction. Allowing more companies to enter a market should, ceteris paribus, increase efficiency and thereby maximise the output that can be produced with the scarce factors of production.

Sometimes, government intervention is however necessary to secure the continued operation of a free market system. This is the case with so-called anti-trust law or competition law. For example, throughout the EU and the United States, strict laws are in place making it illegal for any company to abuse its dominant position in a market. This would be the case when, for example, such a dominant company would lower the price of its own products as it is facing competition only to increase the price again once the competition is eliminated.

Interesting to know

In fact, under European Competition Law, anti-competitive behaviour is assumed when a dominant company, that is, a company able to exercise market power independently of its competitors, sets a price that is lower than its average total cost of production. When the price is merely below the average variable cost of production, the dominant company must prove that it is not abusing its dominant position. On the other hand, if the price is above the average variable cost of production, it is, ceteris paribus, up to the company or authority challenging the dominant firm to prove that it is anti-competitive behaviour.

Labour market reforms

Labour can, in fact, be thought of as a generic name for services provided by humans, and, just like any other service, the price of labour can be determined by supply and demand. However, in many countries the price of labour, wages, is not left completely to market forces. Instead, trade union activity along with minimum wage legislation ensures that the minimum wage is kept high and, in some instances, above market equilibrium. From studying unemployment, you will know that the result in such instances is real-wage unemployment. For companies that nevertheless hire workers, costs are higher than they need be, and this negatively affects production.

By abolishing minimum wage legislation and reducing the power of trade unions, the government can make the labour market more flexible and thus improve potential output. If, at the same time, unemployment benefits are reduced, theory suggests that the flexibility of workers will be further improved as the opportunity cost of not working increases. This should help in reducing frictional unemployment and thus increase the workforce available to firms. However, such policies certainly come at the cost of removing welfare safeguards and lowering the influence of workers, something that goes hand in hand neither with the protection of social and economic-, nor with the protection of civil and political rights.

Income-related policies

By reducing income tax, the government can increase the incentive to work, thereby improving the productivity of workers and increase the number of workers available to firms (increasing the quantity of the labour factor of production). Similarly, reducing business tax and capital gains taxes will allow firms to potentially make higher profits, thereby encouraging investments. Policies such as these are especially popular among right-wing politicians and often go under the name of‘Reaganomics’ thanks to the extensive use that the Republican American President Ronald Reagan made of them.

Interesting to know

In fact, Arthur Laffer, an economist working for Ronald Reagan has been credited with a curve showing that the maximum tax revenue generated by the government at first increases with an increase in the tax rate, only to reach a peak and then decrease if the tax rate is increased any further. This is explained by the fact that a high tax rate acts as a disincentive on people to work hard, and on companies to make investments.


What you should know

  • Supply-side policies are policies aimed at shifting LRAS to the right.
  • Supply-side policies can be either interventionist or market-based.
  • Interventionist policies seek to improve the quantity and quality of the factors of production.
  • Market-based policies seek to maximise the extent to which market forces are allowed to operate freely, thereby increasing competition and efficiency.


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