OxfordAQA International AS and A-level Economics: Supply-side policies (9640)

This guide covers supply-side policies for the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2. It follows section 3.2.4.3. Section 3.2 is International AS content, so it is assessed in the International AS and carries on into the full International A-level. Quantitative skills in section 3.5 can appear alongside any topic, and this guide uses several of them. All figures below are invented for illustration. Country P and the small bakery are made-up examples, not real data.

Use the OxfordAQA Economics hub and the printable checklist to track progress. Companion pages: the revision notes and the practice questions. For the aggregate supply background, see the macroeconomic performance revision notes. Take the free diagnostics first if you are unsure where to start.

What the specification asks for

Specification point	What you must do
Policies versus improvements	Separate government action from changes that happen anyway in the private sector
How policies help	Show how policies can bring supply-side improvements
Incentives and growth	Explain how tax changes aimed at incentives may raise potential output and the underlying trend rate of growth
Macro effects	Analyse effects on unemployment, inflation and the current account of the balance of payments
Named policies	Government spending on education and training, infrastructure, welfare reforms, deregulation and industrial policy

Fiscal and monetary policy have their own sections. Here they appear only as a contrast.

Policies and improvements are not the same thing

A supply-side improvement is any gain in how much the economy can produce, or how efficiently it produces. A supply-side policy is a deliberate government measure meant to bring one about. The specification stresses that improvements often start in the private sector, without government, through invention, innovation, training, investment and rising productivity.

Worked example 1. Output per worker in Country P rises 3.0% in a year. Suppose a study attributes 2.0 percentage points to firms’ own machinery and software, and 1.0 point to a training scheme the government funded. The policy accounts for 1.0 / 3.0 = one third of the gain. Two-thirds would have happened anyway. In evaluation, ask how much of an improvement a policy really caused.

How policies feed into the economy’s capacity

Policies work by adding to the stock of labour and capital, upgrading its quality, or helping firms use it more productively. In the AD/AS model the long-run aggregate supply (LRAS) curve is vertical at the normal capacity level of output. Effective policies shift it to the right. Some also lower firms’ costs and shift short-run aggregate supply (SRAS) to the right. Attitudes, enterprise, factor mobility and incentives all appear in the specification’s list of LRAS determinants, which is why incentives matter.

Worked example 2 (growth accounting). Country P has a labour force of 18.0 million. Potential output = number employed × output per worker.

• Before: 17.1 million employed (95%), output per worker 52,000 currency units (cu). Output = 17.1m × 52,000 = 889.2 billion cu.
• After policies: 17.5 million employed, and output per worker up 3% to 53,560 cu. Output = 17.5m × 53,560 = 937.3 billion cu.
• Change: 937.3 / 889.2 − 1 = 5.4%. Of this, employment grew 2.3% and productivity 3.0%.

A small gain in the trend rate compounds. Suppose trend growth rises from 2.3% to 2.8% for 15 years. Without the change potential output is 1.023^15 = 1.406 times its starting level. With it, 1.028^15 = 1.513. It ends 1.513 / 1.406 − 1 = 7.6% higher. The gain holds only if the higher trend lasts.

Tax changes designed to change incentives

The specification names tax changes that alter incentives. There are two sides.

Personal taxes change the reward for work. A cut in the marginal rate raises the extra take-home pay from each extra hour. Raising the tax-free allowance mainly helps people near the margin of entering work.

Worked example 3. In Country P, tax is 20% on income above an 8,000 cu allowance. A worker earns 26,000 cu. Tax = 0.20 × 18,000 = 3,600 cu.

• Allowance raised to 10,000: tax = 0.20 × 16,000 = 3,200. The worker gains 400. The marginal rate is still 20%, so the reward for an extra hour is unchanged. A person earning 9,000 pays 200 before and nothing after, so the move helps those thinking of entering work.
• Instead, the rate is cut to 17%: tax = 0.17 × 18,000 = 3,060. The gain is 540. Of an extra 1,000 cu earned, the worker keeps 830 instead of 800, up 3.75%.

Which is better depends on the target. A rate cut gives the largest incentive to those already earning. An allowance helps the lowest earners. Evaluation: higher pay can lead some to work fewer hours (the income effect), and any tax cut reduces government revenue unless the tax base grows.

Business taxes change the return on capital spending.

Worked example 4. A bakery chain can buy equipment for 400,000 cu that adds 60,000 cu a year to profit before tax. Pre-tax return = 60,000 / 400,000 = 15%. Its minimum acceptable return after tax is 11%.

• Corporation tax 30%: after-tax profit = 42,000, return = 10.5%. Below 11%, so it does not invest.
• Corporation tax cut to 22%: after-tax profit = 46,800, return = 11.7%. Above 11%, so it invests.

Investment raises the capital stock, which shifts LRAS right. Evaluation: tax cuts also reward firms that would have invested anyway, and investment depends heavily on confidence about demand.

Education and training

Spending on education and training raises human capital, which raises productivity and can reduce structural unemployment by matching workers to jobs. It also has a fiscal side.

Worked example 5. Country P spends 240 million cu on an apprenticeship scheme. 20,000 people complete it, each earning 3,500 cu a year more as a result.

• Extra earnings = 20,000 × 3,500 = 70 million cu a year.
• If the government collects 22% in tax: 3,500 × 0.22 = 770 cu each, so 15.4 million cu a year.
• Payback to the government = 240 / 15.4 = 15.6 years.

The private return is much faster than the public one. Evaluation: benefits arrive late, some trainees would have found work anyway, and skills must match what employers need.

Infrastructure

Roads, ports, broadband and power networks lower firms’ costs and widen markets. They raise productivity across many firms at once and can attract private investment. Budgets are quoted in money terms, so convert to real terms before comparing years (quantitative skill 7). Worked example 6. Capital spending is 3.36 billion cu in a year when the price index is 112 (base year = 100). Real spending = 3.36 / 1.12 = 3.0 billion cu at base-year prices. Evaluation: projects take years to build, cost a lot, and need maintenance. A badly chosen project adds debt without adding capacity.

Welfare reforms

Reforms change the gap between income in and out of work, and so the incentive to take a job. Benefits withdrawn as earnings rise act like a tax on extra earnings.

Worked example 7. A job pays 170 cu a week. Benefit is withdrawn at a rate of 60% of earnings above a 40 cu disregard. (Ignore other taxes.)

• Benefit lost = 0.60 × (170 − 40) = 78. Net gain from working = 170 − 78 = 92 cu.
• Withdrawal rate cut to 45%: lost = 0.45 × 130 = 58.5, so the net gain is 111.5 cu, up 21.2%.

Evaluation: a gentler withdrawal rate costs more in total, since more people qualify for payments, and weakens support for those who cannot work.

Deregulation

Deregulation removes rules that limit entry or raise costs. More entry should raise competition, lower prices and improve efficiency.

Worked example 8. On a coach route, deregulation lets new operators enter. The fare falls from 25 to 21 cu (−16%). Passengers rise from 80,000 to 96,000 (+20%). Price elasticity of demand = +20 / −16 = −1.25, elastic. Revenue rises from 2,000,000 to 2,016,000 cu. Evaluation: rules sometimes protect safety, workers or the environment, and gains may reach consumers more than the economy’s capacity.

Industrial policy

Industrial policy is targeted support for particular industries or regions: subsidies, grants, training funds or research support. It can help where private firms under-invest or where an industry takes time to compete.

Worked example 9. A 90 million cu subsidy is linked to 1,500 jobs, a gross cost of 60,000 cu a job. If 40% of those jobs would have existed anyway, net jobs = 1,500 × 0.6 = 900, and the cost is 90m / 900 = 100,000 cu per net job. Evaluation: governments may “pick losers”, lobbying can distort choices, and other taxpayers fund it.

Effects on unemployment, inflation and the current account

Unemployment. Supply-side policies mainly address structural and frictional unemployment. In a simple flow model, the unemployment rate = s / (s + f), where s is the monthly rate of job loss and f the monthly rate of finding work. This is an illustration, not a specification requirement. If s = 0.6% and f = 12%, the rate is 4.8%. Better matching lifts f to 15%: 0.6 / 15.6 = 3.8%. On a labour force of 6.5 million, unemployment falls from about 309,500 to 250,000. Policies do little for demand-deficient unemployment.

Inflation. Unit labour cost = wage per hour / output per hour. Wages of 18.00 cu and output of 12.0 per hour give 1.50. Wages up 4.5% to 18.81 with output up only 2.5% to 12.3 gives 1.529, up 1.95%. If policy lifts productivity growth to 5.5%, output is 12.66 and the cost is 1.486, down 0.95%.

Worked example 10 (AD/AS). AD: Y = 1,950 − 5P. SRAS: Y = 550 + 9P. Equilibrium: 14P = 1,400, so P = 100 and Y = 1,450. LRAS is at 1,500, a negative output gap of 3.3%. Supply-side policies move SRAS to Y = 620 + 9P: 14P = 1,330, P = 95, Y = 1,475. The price level falls 5.0%, output rises 1.7%. If LRAS also moves up 3% to 1,545 and AD is unchanged, the gap widens to (1,475 − 1,545) / 1,545 = −4.5%. Unless demand grows too, extra capacity stands idle.

Current account. Higher productivity and lower costs raise price and quality competitiveness. Country P’s exports of goods are 660 and imports 705, a deficit of 45. After policies exports rise 4.5% to 689.7 and imports fall 2.0% to 690.9, a deficit of 1.2. The current account also includes income and transfers, so the full balance may differ.

Common errors

• Describing a private-sector improvement as a policy.
• Writing that supply-side policies work quickly. Most take years.
• Saying a tax cut always raises output. Say what it changes: the incentive, the return, or the cost.
• Ignoring the demand side. Extra capacity needs spending to use it.
• Evaluation with no judgement. Conclude, then give the condition your conclusion depends on.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), specification version 1.2, section 3.2.4.3 Supply-side policies and section 3.5 Quantitative skills. First teaching September 2020; first International AS exams May/June 2021; first International A-level exams May/June 2022. Published by OxfordAQA.