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

This guide teaches 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): supply-side policies. The content belongs to Unit 2, Macroeconomic performance and policy. Per the specification, Unit 1 and Unit 2 make up International AS (IAS), while Unit 3 and Unit 4 supply the additional International A2 (IA2) content. Supply-side policy is IAS material that carries into the full International Advanced Level. Every figure below is invented and illustrative.

Related pages: the revision notes, the practice questions, the course hub, the printable checklist, and a free diagnostic. For the AS/AD background see aggregate supply and equilibrium and the growth guide. Statements 1, 2 and 4 of 2.3.6 (objectives, conflicts, demand-side policy) are taught elsewhere.

Specification coverage

Ref	You must be able to
2.3.6 (3a)	Explain supply-side policies designed to increase productivity, competition and incentives
2.3.6 (3b)	Explain free market policies: deregulation of product and labour markets, privatisation, reduction in taxation, changing the levels of welfare payments, cutting the costs of bureaucracy for firms
2.3.6 (3c)	Explain interventionist policies: investment in education, training and skills; incentives to encourage investment (tax incentive or subsidies); infrastructure investment; finance for business start-ups; regional policy
2.3.6 (3d)	Assess the strengths and weaknesses of different supply-side policies

1. The aim: shift long-run aggregate supply (3a)

Supply-side policies try to raise the productive capacity of the economy. If they work, long-run aggregate supply (LRAS) shifts right. In words: put the general price level up the side and real output along the bottom; the vertical LRAS curve moves from LRAS1 to LRAS2, to the right of the full-employment output Y1, so potential output rises to Y2 and the economy can grow without upward pressure on prices.

Price level
 |        LRAS1   LRAS2
 |         |       |
 |         |       |
 |         |       |
 +---------+-------+------ Real output
          Y1      Y2

The specification groups the aims under three headings.

• Productivity: more output per worker or per hour, through skills, capital and technology.
• Competition: more rivalry pushes firms to cut costs and innovate.
• Incentives: the reward for working, saving, investing and starting a business.

Productivity is output divided by the input used, usually labour.

Worked example 1 (Country A, illustrative). Real GDP is 480 billion currency units (cu) and 12.0 million people work. After a skills programme, real GDP is 504 billion cu with the same workforce.

• Output per worker before: 480 billion / 12.0 million = 40,000 cu.
• Output per worker after: 504 billion / 12.0 million = 42,000 cu.
• Change: (42,000 / 40,000) - 1 = 5.0%.
• If each worker puts in 1,600 hours, output per hour rises from 25.00 cu to 26.25 cu.

Always say whether output per worker or per hour is used. Hours matter, because a rise in output per worker can come from longer hours rather than better productivity.

2. Free market policies (3b)

Free market policies cut the state’s role. The argument is that markets allocate resources better, so removing barriers and raising rewards lifts supply.

Deregulation of product and labour markets. Fewer rules on entry, licences, opening hours, hiring and firing make markets more contestable. In product markets, new entrants raise competition, so firms face pressure to cut costs and lower prices. In labour markets, easier hiring and firing and weaker restrictions on pay-setting lower the cost of taking on workers and raise labour mobility. Weakness: lighter rules can leave workers with less security and lower pay, and can allow harm to consumers, workers or the environment that the rules were written to prevent.

Privatisation. Moving a state-owned firm into private hands exposes managers to the profit motive and to shareholders. The chain: private owners want profit, so they cut waste, unit costs fall, and if the market is competitive prices fall too. Weaknesses: a public monopoly can become a private monopoly with more market power, and the firm may drop unprofitable but socially valuable services. Privatisation raises one-off revenue for the government, but that is a fiscal gain, not the supply-side effect itself.

Illustrative case: a state rail firm has unit cost 50 cu per journey. After privatisation, unit cost is 44 cu: (44 / 50) - 1 = -12%. Whether passengers gain depends on whether that saving reaches prices, which depends on competition or regulation.

Reduction in taxation. Lower income tax raises the reward from work, so some people may enter work or work more hours. Lower corporation tax raises the return on investment and may attract foreign direct investment (FDI). The incentive depends on the marginal rate, the rate on the next unit earned.

Worked example 2 (Country A, illustrative). The top marginal income tax rate falls from 40% to 35%. A worker earning an extra 1,000 cu keeps 600 cu before and 650 cu after, a rise of 650/600 - 1 = 8.3% in take-home pay from extra effort.

Revenue effect: before the cut, a taxable base of 200 billion cu at 40% raises 80 billion cu. If the base grows to 220 billion cu at 35%, revenue is 77 billion cu, a fall of 3 billion cu. To keep revenue at 80 billion cu, the base would need to reach 80 / 0.35 = 228.6 billion cu, a rise of 14.3%.

Evaluation: the extra work may be small if people have little choice over hours (a low wage elasticity of labour supply), and higher earners may use the extra income to save or to work less (the income effect). The gain to supply is therefore uncertain, while the loss of revenue may limit spending on public services.

Changing the levels of welfare payments. The usual free market policy cuts or tightens benefits so that work pays more than being unemployed. The replacement rate is benefit divided by the net wage from working.

Worked example 3 (illustrative). Out-of-work benefit is 144 cu a week; net pay from a job is 192 cu.

• Gain from working: 192 - 144 = 48 cu. Replacement rate: 144 / 192 = 75%.
• Benefit cut to 120 cu: gain 72 cu (+50%), replacement rate 120 / 192 = 62.5%.

The incentive improves, but weaknesses are that poverty and inequality rise, a person with no vacancies to apply for gains nothing from a cut, and the lost spending can lower demand.

Cutting the costs of bureaucracy for firms. Simpler tax filing, fewer permits and quicker planning decisions cut compliance costs. Lower costs raise profit and short-run supply for each firm and may encourage start-ups. Weakness: some rules protect safety, so cutting them has costs, and the cost saving per firm may be small.

3. Interventionist policies (3c)

Interventionist policies use state spending or subsidy to correct market failure, such as firms under-investing in training because workers may leave.

Investment in education, training and skills. This raises human capital, so productivity rises. It also raises occupational mobility, which can cut structural unemployment. Weaknesses: large time lags, since a child entering school today joins the labour force years later, a high opportunity cost, and the risk that skills do not match what employers need.

Incentives to encourage investment. A tax incentive (such as allowing capital spending to be deducted from taxable profit) or a subsidy lowers the cost of capital. More capital per worker raises productivity.

Worked example 4 (Country A, illustrative). A scheme pays a 15% subsidy on new machinery. 50 firms each buy machinery worth 4 million cu. Evidence suggests 30 of those firms would have bought it anyway.

• Cost to government: 50 x 0.15 x 4 million = 30 million cu.
• Extra investment caused: 20 firms x 4 million = 80 million cu.
• Cost per cu of extra investment: 30 / 80 = 0.375 cu.

The 30 firms’ payments (18 million cu) are deadweight, meaning money spent on spending that would have happened anyway. Always ask whether the policy changes behaviour.

Infrastructure investment. Roads, ports, broadband and energy networks cut firms’ costs and widen markets. Because infrastructure is often a public good or needs huge up-front finance, the private sector may under-provide it. Weaknesses: high cost, long build times, and poor project choices (government failure).

Finance for business start-ups. Small firms often struggle to borrow because banks lack information about them. Loans, loan guarantees or grants raise entry and competition. Weakness: many start-ups fail, and public money may back weak ideas.

Regional policy. Targets areas of high unemployment or low income with subsidies, relocation grants for firms, and infrastructure.

Worked example 5 (illustrative). Region N has a labour force of 2.0 million and unemployment of 9%.

• Unemployed: 0.09 x 2,000,000 = 180,000.
• A policy brings 40,000 new jobs, all filled by the local unemployed, and the labour force stays at 2.0 million.
• Unemployed after: 140,000. Rate: 140,000 / 2,000,000 = 7.0%.

If jobs went to commuters or migrants, the fall would be smaller. Regional policy can also raise local house prices and leave firms dependent on subsidy.

4. Strengths and weaknesses (3d)

Use the same set of criteria to judge any policy.

Criterion	Question to ask
Time lag	How long before supply rises? Education is slow; deregulation can be quick
Cost and opportunity cost	What does the government give up? Tax cuts and subsidies cost revenue
Size of effect	Does the response of workers and firms to the incentive matter in practice?
Equity	Who gains and who loses? Benefit cuts hit low earners
Reversibility and uncertainty	Will firms and workers behave as predicted?
Link to other objectives	Growth, inflation, the budget, the environment, inequality

Free market policies tend to be cheaper and quicker to introduce but widen inequality and rely on markets responding. Interventionist policies tackle market failure directly but cost more, take longer and risk government failure.

Worked example 6 (compounding, illustrative). Potential output grows at 2.5% a year. Policies raise the trend to 3.0% for 10 years.

• 1.025^10 = 1.2801 and 1.03^10 = 1.3439.
• Potential output ends 1.3439 / 1.2801 - 1 = 5.0% higher than without the policy.

A small change in the trend rate compounds. It also shows why a policy with a long lag can still be worth the cost.

A model evaluative chain. Cutting income tax (a) raises the reward to work, (b) so more people enter work or work longer, (c) so the labour supply and potential output rise, (d) so LRAS shifts right. Judge it: how large is (b)? How long does it take? Who gains? Is revenue lost? Then reach a conclusion that depends on conditions rather than a stock answer.

Common errors

• Writing “supply-side policy raises AD.” The target is LRAS; any AD effect is a side effect (a tax cut or subsidy can raise demand too).
• Calling a tax cut interventionist. The specification files reductions in taxation under free market policies and tax incentives or subsidies for investment under interventionist ones.
• Giving only strengths for a policy in an assessment question.
• Forgetting that benefit cuts help supply only if jobs exist.
• Stating that privatisation always lowers prices.

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).