AQA A-level Economics: Supply-side policies (7136)

This guide covers supply-side policies for AQA A-level Economics (7136), from the AQA AS and A-level Economics specification, version 1.3. The AQA website numbers the sub-section 3.2.5.2. The combined specification PDF prints the A-level content as 4.2.5.2, and the specification gives no AS-only or A-level-only labels there.

Every number below is invented and illustrative. Country K, its firms and its figures do not exist. Track progress with the AQA A-level Economics hub and the printable checklist, and find weak spots with the free diagnostics. Companion pages: revision notes and practice questions. For the AD/AS model see aggregate demand and supply; for the natural rate see employment and unemployment.

What you must be able to do

Specification point	You should be able to
Policies versus improvements	Say what separates a government policy from a supply-side change that happens anyway
How policies help	Link a policy to better productivity, capacity or incentives
Incentives and potential output	Explain how tax changes may raise potential output and trend growth
Unemployment, prices, external performance	Trace effects on jobs, the rate of change of prices and the current account
Natural rate	Explain how policies may reduce the natural rate of unemployment
Free market measures	Tax cuts, privatisation, deregulation, some labour market reforms
Interventionist measures	Spending on education and training, industrial policy, R&D subsidies
Micro and macro effects	Show that policies change individual markets as well as the whole economy
Short-termism	Explain it as a market failure that can justify intervention

1. Policies versus improvements

A supply-side improvement is any rise in the economy’s productive capacity or efficiency: more or better labour and capital, better technology, better organisation. A supply-side policy is a deliberate government action intended to bring one about.

The two are not the same. The specification stresses that supply-side changes often start in the private sector, independently of government, through productivity gains, innovation and investment. A bakery chain that buys faster ovens, or a firm that trains its own staff, improves supply without any policy. Policy matters when the private sector will not deliver enough alone, or when the rules and incentives block it.

Worked example 1. In Country K a firm’s output per worker-hour rises from 20 to 22 units after it adopts new machinery. Change: (22 − 20)/20 = 10%. No government action was involved, so this is an improvement but not a policy. If the government had subsidised the machinery, it would be a policy-assisted improvement. Judging how far a result was caused by policy is the hard part of evaluation.

2. How policies raise potential output and trend growth

Supply-side policies aim to shift long-run aggregate supply (LRAS) to the right. Potential output is what the economy can produce when resources are fully employed. The trend rate of growth is the average rate at which potential output rises over time. Policies can work through three routes:

• more resources: more workers, more capital;
• better quality: skills, technology, management;
• stronger incentives: higher rewards for working, saving, investing and innovating.

Tax changes designed to change personal incentives are the specification’s example. A cut in the marginal rate of income tax raises the reward for each extra hour, so some people may work more or join the labour force. A cut in corporation tax, or an allowance against tax for investment, raises the post-tax return on capital spending.

Worked example 2 (Country K, illustrative). The marginal income tax rate falls from 30% to 24%. On an extra 500 cu earned, the worker keeps 350 cu before and 380 cu after, a rise of 30/350 = 8.57%. Suppose hours supplied respond with an elasticity of 0.4 to the net wage. Hours rise by 0.4 × 8.57% = 3.43%. With 2,000 million hours worked and output of 30 cu per hour, extra hours are 68.6 million, worth about 2,057 million cu of extra output.

The elasticity of 0.4 is an assumption. For some workers a higher net wage lets them work fewer hours (the income effect outweighs the substitution effect), and the response could be near zero. The policy also loses tax revenue per hour worked.

Worked example 3 (compounding). Policies lift trend growth from 1.8% to 2.2% for 12 years. Potential output is 1.018^12 = 1.2387 times today’s level without the policies, and 1.022^12 = 1.2984 times with them. It ends 1.2984/1.2387 − 1 = 4.8% higher. A small change in trend growth builds into a large gap, but only if the change lasts.

AD/AS sketch in words. The vertical axis is the price level and the horizontal axis is real output.

• LRAS is vertical at potential output Y1, and a successful policy shifts it right to Y2.
• SRAS shifts right with it.
• At unchanged AD, equilibrium moves to a lower price level and higher real output, but potential output has risen too, so actual output only reaches the new capacity if AD also grows.

3. Effects on unemployment, prices and the current account

Unemployment and the natural rate. The natural rate of unemployment is the rate when the labour market is in equilibrium: it includes frictional and structural unemployment but no cyclical unemployment. Supply-side policies target the structural part. Training matches skills to vacancies. Better job information and lower benefit dependence shorten search. Lower barriers to hiring raise the demand for labour.

Worked example 4. Country K has a labour force of 40 million and a natural rate of 6.0%, so 2.4 million are unemployed at equilibrium. Retraining lowers the natural rate to 5.2%: 40 × 0.052 = 2.08 million. Equilibrium unemployment falls by 0.32 million. Because demand management cannot lower the natural rate without causing inflation, this is a permanent gain that only supply-side action delivers.

Inflation. The rate of change of prices falls if costs fall or capacity grows. Higher productivity cuts unit labour costs: wage per hour divided by output per hour.

Worked example 5. Wages are 24 cu an hour and output is 20 units an hour, so unit labour cost is 1.20 cu. If productivity rises to 22 units: 24/22 = 1.091, down 9.1%. If wages then rise 5% to 25.2 cu, unit labour cost is 25.2/22 = 1.145, still 4.5% below the original 1.20. Productivity gains can therefore absorb wage rises without pushing up prices. Lower unemployment at the new natural rate also reduces wage pressure.

Current account. Lower costs make exports cheaper in foreign markets and domestic goods cheaper against imports, improving price competitiveness. Better quality and new products raise non-price competitiveness too.

Worked example 6. Country K exports goods and services worth 400 and imports worth 430, a deficit of 30 on that part of the current account. After supply-side improvements exports rise 5% to 420 and imports fall 3% to 417.1, a surplus of 2.9. The current account also includes income and transfers, so say “improve” rather than “eliminate”.

4. Free-market and interventionist policies

	Free-market (market-based)	Interventionist
Idea	Remove obstacles, strengthen incentives, increase competition	Government acts directly to correct market failure
Measures	Tax cuts, privatisation, deregulation, some labour market reforms	Spending on education and training, industrial policy, R&D subsidies
Cost	Revenue forgone	Spending and opportunity cost
Main risk	Inequality; market failures remain	Government failure; poor targeting

Free-market measures.

• Tax cuts raise incentives to work, invest and start businesses.
• Privatisation transfers assets to private owners, with the aim of profit-driven efficiency. Gains depend on whether competition replaces the old monopoly.
• Deregulation removes rules that restrict entry or practices. More firms mean more competition and lower costs.
• Labour market reforms can include changes to benefits, to union powers or to hiring and firing rules. The specification says “some” reforms, so name the specific reform and its mechanism.

Interventionist measures.

• Education and training spending raises human capital and the quality of labour.
• Industrial policy supports particular industries, regions or infrastructure.
• Subsidising research and development (R&D) raises innovation, which has positive externalities.

Worked example 7 (Country K, training). A scheme costs 600 million cu and trains 30,000 workers. Cost per worker: 20,000 cu. Each trained worker earns 4,000 cu more each year, so the group gains 120 million cu a year, and the scheme takes 600/120 = 5 years to repay itself. Over 8 years the undiscounted gain is 960 million cu, which falls to about 776 million cu at a 5% discount rate. The benefit is real but arrives late, and some trained workers might have found work anyway.

Worked example 8 (R&D subsidy). A research project costs a firm 10 million cu and brings it private benefits of 8 million cu, so it is not worthwhile (net −2). The wider economy gains a further 5 million cu in spillovers, so the social benefit is 13 million cu and the social net gain is 3 million cu. A 30% subsidy cuts the firm’s cost to 7 million cu, giving it a net gain of 1 million cu, so it proceeds. The government pays 3 million cu for a social net gain of 3 million cu. The result depends on the spillover estimate being right.

5. Short-termism

Short-termism is a bias towards short-run results at the expense of long-run returns. Managers or shareholders may demand quick payback, which discourages investment in research, training and equipment. Training also carries a poaching risk: a firm may not train staff if rivals can hire them. This is a market failure, and it is why the specification links intervention to it.

Worked example 9. A project costs 100 million cu now and returns 30 million a year for 5 years. Payback is 100/30 = 3.33 years. A firm that insists on payback within 3 years rejects it. At a 12% discount rate the present value of the returns is 30 × 3.605 = 108.1 million, so net present value is about +8.1 million cu. The project is worthwhile; the short payback rule is what blocks it. Government tax allowances for investment or R&D subsidies can offset this bias.

6. Microeconomic as well as macroeconomic effects

Policies work through individual markets. In Country K’s taxi market, demand is Qd = 120 − 4P and supply is Qs = 20 + 4P, with price in cu and quantity in thousand rides. Equilibrium: P = 12.5 and Q = 70. Deregulation that lets new operators enter shifts supply to Qs = 40 + 4P. The new equilibrium is P = 10 and Q = 80. Price falls 20% and quantity rises 14.3%. Consumer spending falls from 875 to 800 (thousand cu), because demand is price inelastic over this range (a 14.3% rise in quantity for a 20% fall in price). Effects on specific markets include prices, output, employment and the distribution of income, and some groups, such as existing licence holders, lose.

Evaluating supply-side policies

• Time lags: education and R&D can take years; tax and deregulation effects may be faster.
• Cost and opportunity cost: spending on training competes with other uses of funds.
• Uncertainty: incentive responses depend on elasticities that are hard to predict.
• Distribution: tax cuts can widen inequality; interventionist policies can narrow it.
• Size and context: the effects depend on how far the economy is from capacity and on private-sector behaviour.
• Government failure: poor targeting can waste money or favour the wrong industries.

Common errors

• Treating a private-sector gain as a government policy.
• Claiming demand-side measures lower the natural rate.
• Saying every tax cut raises potential output; it only does if behaviour changes.
• Showing LRAS shifting right but forgetting the output gap and price level story.
• Listing policies without linking each one to a mechanism and an outcome.

Official syllabus

AQA, AS and A-level Economics specification, version 1.3 (29 June 2022), A-level content section 4.2.5.2 in the combined PDF (3.2.5.2 on the AQA website): Supply-side policies. Published by AQA.