What supply side policies are
Supply side policies aim to increase the productive capacity of the economy — how much it is able to produce — rather than how much is being demanded.
That is the distinction from the other two policies, and it is the one questions test. Fiscal and monetary policy work on demand: they change how much people want to buy. Supply side policy works on supply: it changes how much the economy can make. So while a demand policy can raise output only up to the limit of what the economy can produce, a supply side policy raises the limit itself.
- Supply side policies
- policies aiming to increase the productive capacity of the economy — how much it is able to produce — rather than how much is being demanded
Evaluating supply side policy
The benefits are unusual in that supply side policy can serve several objectives at once, where demand policies trade one off against another:
• Economic growth, because the economy can produce more • Low unemployment, because retrained workers can take the jobs that exist and firms expand • Price stability, because greater capacity means demand can rise without pushing prices up — supply side policy is the one route to growth that does not risk inflation • A stronger balance of payments, because more competitive firms export more
The costs are equally distinctive:
The time lag is long. Educating and training a workforce takes years, and infrastructure takes years to build, so nothing helps a recession happening now. Demand policies act far faster.
The opportunity cost is real and the specification names it. Money spent on training schemes, infrastructure or subsidies cannot be spent on anything else, and tax cuts reduce revenue. Either way, other public spending is given up, or borrowing rises.
The outcome is uncertain. A tax cut intended to make people work more may simply be saved. A training scheme may teach skills employers do not want. Deregulation may cut costs but at the price of worse working conditions or environmental damage, and reducing benefits to sharpen the incentive to work hits those who cannot find work at all.
And it does not help if demand is the problem. Raising an economy's capacity to produce achieves nothing if nobody is buying what it already makes.
Worked example
A region has high long-term unemployment following the closure of its main manufacturing industry. Recommend a policy and evaluate it.
- Diagnose the type of unemployment: the industry has gone, so this is structural, not cyclical.
- That rules out simply raising demand — the old jobs no longer exist to be filled.
- The matching response is a supply side policy: retraining workers in skills the growing sectors need.
- Add a second measure that supports it, such as investment in transport links or incentives for firms to locate there.
- Now the drawbacks, and make them specific.
- Training takes years, so unemployment continues meanwhile, and the money has an opportunity cost.
- The training must match real vacancies, or it achieves nothing.
Answer: A supply side policy: government-funded retraining in the skills that growing industries need, supported by investment in transport links and incentives for firms to locate in the region. This addresses the actual cause — workers whose skills no longer match available jobs — which raising demand would not do, since the old jobs are gone. The drawbacks are that training takes years, so unemployment persists in the meantime; the spending has an opportunity cost, since the money could have gone to health or education elsewhere; and the scheme only works if the skills taught match vacancies that genuinely exist in the area.
Common mistake
Supply side policy does not raise demand. It raises the economy's capacity to produce. Using it against a recession caused by weak demand is the wrong tool — and using demand policy against structural unemployment is the same error in reverse.
Before you practise
- Supply side policies increase the economy's productive capacity.
- Fiscal and monetary policy work on demand; supply side policy works on supply.
- Examples: education and training, infrastructure, tax cuts, subsidies, deregulation and encouraging competition.
- Most work by raising productivity.
- They can serve growth, employment and price stability at the same time.
- They are the only route to growth that does not risk inflation.
- They act slowly — training and infrastructure take years.
- They carry an opportunity cost, since the money or lost revenue has other uses.
- Outcomes are uncertain, and deregulation may cost working conditions or environmental protection.
- They do not help if the problem is weak demand.