Pearson Edexcel International Advanced Level Economics: Supply-side policies (YEC11) – Revision Notes

These notes condense statement 3 of 2.3.6 Macroeconomic objectives and policies in the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018). Unit 2 is one of the International AS (IAS) units and also counts towards the full International Advanced Level; Units 3 and 4 add the International A2 content. For full explanations use the study guide; for exam-style work use the practice questions. Also see the course hub, the printable checklist and the free diagnostics. All figures are invented and illustrative.

Core idea (3a)

Supply-side policies aim to raise potential output, shown as a rightward shift of the vertical long-run aggregate supply curve (general price level up the side, real output along the bottom). They work through three routes.

Route	Meaning	Example policy
Productivity	More output per worker or per hour	Training, investment, infrastructure
Competition	More rivalry, lower costs, more innovation	Deregulation, privatisation with competition, start-up finance
Incentives	Greater reward for work, saving and investment	Income tax cuts, welfare changes, investment allowances

Sorting the policies (3b and 3c)

Free market (3b)	Interventionist (3c)
Deregulation of product and labour markets	Investment in education, training and skills
Privatisation	Tax incentives or subsidies for investment
Reduction in taxation	Infrastructure investment
Changing the levels of welfare payments	Finance for business start-ups
Cutting the costs of bureaucracy for firms	Regional policy

Rule of thumb: free market policies shrink the state’s role; interventionist policies use state money or action to correct a market failure.

Policy cards

Deregulation. Chain: fewer barriers to entry, more firms, more competition, lower costs and prices, higher productivity. Labour version: easier hiring raises labour mobility and lowers the cost of taking on workers. Weakness: less protection for workers, consumers and the environment.

Privatisation. Chain: profit motive, cost cutting, lower unit costs, possibly lower prices. Weakness: private monopoly, loss of unprofitable services, short-run job losses. One-off sale revenue is a fiscal gain, not a supply-side effect.

Tax reduction. Lower marginal rates raise the reward to work; lower corporation tax raises returns to investment and may attract foreign direct investment. Weakness: small response if labour supply is inelastic, income effects, lost revenue, and benefits go mainly to higher earners.

Welfare changes. Lower or tougher-to-claim benefits raise the gain from working. Weakness: inequality, and no effect if there are no vacancies.

Cutting bureaucracy. Lower compliance costs, more start-ups. Weakness: some rules protect safety; savings may be small.

Education, training and skills. Higher human capital, higher productivity, better occupational mobility. Weakness: long time lag, high cost, skill mismatch.

Investment incentives. More capital per worker. Weakness: deadweight, since some firms would have invested anyway, and the policy depends on firms’ confidence.

Infrastructure. Lower costs, wider markets, supports growth. Weakness: very costly and slow, and poor project choice is government failure.

Start-up finance. Eases borrowing constraints for new firms. Weakness: many fail.

Regional policy. Reduces regional unemployment and inequality. Weakness: dependency on subsidy and firms may leave when support ends.

Formulas and methods

Item	Formula
Productivity	Output / number of workers (or hours)
Percentage change	(new / old - 1) x 100
Replacement rate	Benefit / net wage from work
Tax revenue	Tax rate x taxable base
Break-even base for a tax cut	Old revenue / new tax rate
Cost per unit of extra investment	Subsidy cost / additional investment caused
Compound growth	Starting value x (1 + g) raised to the number of years

Method for a tax-cut revenue question.

1. Revenue before = old rate x old base.
2. Revenue after = new rate x new base.
3. Break-even base = old revenue / new rate.
4. Express the rise in base needed as a percentage.

Small worked reminders.

• Output 150 billion cu with 5.0 million workers is 30,000 cu per worker. Output of 156 billion cu gives 31,200 cu, a rise of 4.0%.
• Benefit 90 cu and net wage 150 cu give a replacement rate of 60%. A cut in benefit to 75 cu gives 50%.
• Tax rate 25% on a base of 400 billion cu raises 100 billion cu. At 20%, the base must reach 100 / 0.20 = 500 billion cu, a rise of 25%.
• Compounding: 2% growth for 5 years gives 1.1041; 3% gives 1.1593. Potential output ends 5.0% higher on the faster path.

Evaluating: the set of criteria

Time lag, cost and opportunity cost, size of the response, equity, certainty, and effect on other objectives. A good judgement picks the criteria that matter in the case given and names the condition on which the answer turns. For example, if unemployment is structural, training suits better than a demand stimulus; if firms face high red tape, deregulation may deliver faster.

Matching policy to problem

Problem	Policy that fits	Main limit
Workers lack skills employers want	Education, training and skills	Slow, costly
Weak incentive to take a job	Tax cut, welfare change	Inequality, lost revenue
Firms face high compliance costs	Cutting bureaucracy, deregulation	Weaker protection
Low investment per worker	Tax incentives, subsidies	Deadweight
High costs of moving goods and people	Infrastructure	Cost, long build time
New firms cannot borrow	Start-up finance	High failure rate
One area has high unemployment	Regional policy	Dependency
State firm is inefficient	Privatisation	Monopoly power

Method for a policy evaluation answer

1. Define the policy in one line and place it as free market or interventionist.
2. Give a chain of at least three links ending in a shift of LRAS or higher productivity.
3. Add a second line of analysis: a cost, a time lag or a side effect on another objective.
4. Weigh it against a rival policy using two or three criteria.
5. Finish with a judgement tied to a condition, such as how strongly people respond or which kind of unemployment is present.

Short model paragraph. Training subsidies raise the skills of workers, so output per worker rises and LRAS shifts right. The effect is slow, because trained workers take years to arrive, and costly, because the budget has to find the money. A tax cut could act faster but it favours higher earners and loses revenue. Which is better depends on whether the main problem is skills or the reward for working.

Must-know distinctions

• Free market versus interventionist: tax reductions are free market; tax incentives or subsidies for investment are interventionist.
• Supply-side versus demand-side: supply-side policy targets potential output (LRAS); demand-side policy targets aggregate demand.
• Short-run versus long-run effect: a subsidy can raise demand quickly but raises capacity only slowly.
• Output per worker versus output per hour.

Quick self-test

1. Is a cut in the top income tax rate a free market or an interventionist policy?
2. Is finance for business start-ups a free market or an interventionist policy?
3. Output rises from 150 billion cu to 156 billion cu with 5.0 million workers. Find the percentage rise in output per worker.
4. Benefit is 90 cu and net pay is 150 cu. Find the replacement rate, then find it after benefit falls to 75 cu.
5. Tax at 25% on a base of 400 billion cu is cut to 20%. Find the base that keeps revenue unchanged.
6. State what is meant by deadweight in an investment subsidy scheme.
7. Potential output grows at 2% a year for 5 years, then at 3% for 5 years from the same start. By what percentage is the 3% path higher after 5 years?
8. A privatised firm cuts unit cost from 40 cu to 36 cu. Find the percentage change.
9. Give two weaknesses of spending more on education and training.
10. Describe in words the diagram that shows a successful supply-side policy.

Answers

1. Free market (reduction in taxation).
2. Interventionist.
3. 156 / 5.0 = 31,200 cu per worker and 150 / 5.0 = 30,000 cu, so a rise of 4.0%.
4. 90 / 150 = 60%; 75 / 150 = 50%.
5. 25% x 400 = 100 billion cu; 100 / 0.20 = 500 billion cu, so the base must rise by 25%.
6. Subsidy paid for investment that firms would have undertaken without it, so it does not add to total investment.
7. 1.03^5 = 1.1593, 1.02^5 = 1.1041; 1.1593 / 1.1041 - 1 = 5.0%.
8. (36 / 40 - 1) x 100 = -10%.
9. Any two: long time lag; high cost and opportunity cost; skills may not match employers’ needs; trained workers may leave the area or country.
10. With the price level up the side and real output along the bottom, the vertical LRAS curve shifts right from Y1 to Y2, so potential output rises.

Where marks are usually lost

• Describing a policy without explaining the chain to higher supply.
• Mixing up free market and interventionist categories.
• Treating a tax cut as only a supply-side measure and ignoring its demand effect.
• Giving a list of strengths or weaknesses with no judgement.
• Ignoring time lags when comparing policies.
• Calculating a percentage change from the wrong base.
• Forgetting that a welfare cut works only if vacancies exist.
• Quoting figures with no source or label; say when a figure is illustrative.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018, Pearson Education Limited: section 2.3.6, statement 3 (a-d).