Supply Side Economics

Supply side economic policy is a set of government initiatives that aim to improve the economic performance of markets and industries. Policies tend to be more microeconomic because they focus of individual economic agents. Policies aim to:

· Increase competition within markets

· Increase efficiency within markets

· Increase the economy’s potential production – PPF/LRAS (see here for more)

Supply side fiscal policy

· Creating personal incentives to improve economic performance of the supply-side of the economy

· Since 1979, supply-side fiscal policy had been used by Labour and Conservative governments

· Supply-side economists believe that high levels of government spending, taxation and borrowing lead to crowding out (see below) of the public sector.

The intended effects of supply-side policies are shown below:

It is the free market view that supply-side policies should be used to increase efficiency and competition within markets.

Crowding out

Resource crowding out

Assuming there is no spare capacity in the economy and full employment of all resources, resource crowding out is when employing more labour and capital in the public sector sacrifices the use of the same resources by the private sector. Resource crowding out does not happen when there is spare capacity in the economy because government spending can be seen as ‘picking up the slack’ of the private sector. The private sector can be stimulated and crowding in can occur.

Financial crowding out

Increasing taxes to facilitate for high levels of government expenditure reduces the spending power of private sector firms.

Absolute and Comparative Advantage

Absolute Advantage

A country specialises in what it does best. It is technically and productively efficient at producing the good (after taking into account administrative and transport costs). This can be determined by natural factors such as land or climate. It is important to remember that when a country has absolute advantage, they must make sure that there is demand for the good/service they are providing, thus enabling trade to occur.

Comparative Advantage (CA)

A country has the lowest opportunity cost when producing the good. If a country wishes to increase production in one particular commodity, it must give up the least of the another commodity to have the CA. The CA is the case for free trade because it enables countries to trade.

A country that has an absolute advantage may not necessarily have the competitive advantage.

If countries specialise in activities which they possess a comparative advantage, they can trade their surpluses and the result will be gains in output and welfare.

Assumptions upon which the CA relies upon (and therefore assumptions which the case for free trade relies upon)

·     The country’s factors of production are fixed and factors can only be switched between industries (which means the country can change what they specialise in).

·     Finished goods are mobile between countries.

·     There are constant returns to scale. If this assumption were to be dropped, the country can experience decreasing returns to scale whereby increasing the scale of the factors of production leads to a less proportionate rise in output. This causes inefficiencies therefore the country cannot have the CA. If there are increasing returns to scale, the country is allocating more scarce resources to produce more output which compromises the production of other goods, leading to a greater opportunity cost. Also, in the long run, production can become unsustainable, for example, producing one single agricultural product (monoculture), can lead to soil erosion, vulnerability to pests and falling yields.

·     There are stable demand and cost conditions. If demand conditions were unstable or new technologies caused costs to change, the country would loose its comparative advantage because, again, inefficiencies will result.

Monopoly

·     A few firms dominating the market. Actual monopolies (only one firm in the market) are very rare.

Monopoly Equilibrium

The profit maximisation point is Q1 and P1, where MR=MC. The equilibrium quantity is Q1, however the equilibrium price is not P1. Instead the firm charges P3 since P3 is the maximum price the monopolist firm can charge while succeeding at selling quantity Q1.

Therefore the total revenue gained by the firm is rectangular area P3XQ1O. The total costs the firm incurs is the rectangular area P2YQ1O. The supernormal profits that the monopoly firm makes is P3XQ1O - P2YQ1O (total revenue minus total costs), which equals P3XYP2. This profit is the monopoly profit that the firm makes.

The monopoly IS the industry and therefore there is no separate market demand and supply diagram (like with perfect competition, see here and here). They get combined and put together because the market is the monopoly. AR is downward sloping because if they set a large price, following the law of demand, the number of units they will sell will fall and vice versa.

This diagram is the long run equilibrium and the short run equilibrium. Barriers of entry prevent new firms entering the market, thus monopoly profits are sustained in the long run as well. Firms want to be monopolies because monopoly firms sustain supernormal profits in the long run.

Efficiency

For a monopolistic market, the firm is…

·     NOT allocatively efficient. The firm does not produce above quantity Q1. Price does NOT equal MC.

·     Not productively efficient because it is not producing at its cost minimising point (the lowest point on the AC curve).

Benefits of a monopoly:

·     Market can benefit from economies of scale due to lower ACs.

·     Supernormal profits can be used for R&D.

This model, like perfect competition, can be used to compare real life markets with.

Perfect Competition Long Run Equillibrium

Long run equilibrium

Because supernormal profits can be made in the short run, new firms enter the market.

When new firms enter the market, market supply increases from MS1 to MS2 which drives the price down from P1 to P2. There is a new equilibrium of price P2 and quantity Q2. For the individual firm in the market (diagram on the right), the firm now charges price P2 leading to MR and AR moving down to P2 as well. Point Y is the profit maximisation point (MR2=MC), therefore the firm will sell at quantity Q2 and total revenue gained is the rectangular area P2YQ2O. Because AC=MC, the rectangular for the firm’s total costs is P2YQ2O as well. This means that supernormal profits are not being made, only normal profits are being made. Costs per unit are equal to revenue per unit and so the firm is unable to make supernormal profits in the long run. Price = Long run ACs as well.

Furthermore, the firm is producing fewer units of output. Because there are no supernormal profits being made by firms within the market, there is no incentive for firms to enter or exit the market and the market is said to be at rest.

Efficiency

In the LR in a perfectly competitive market, there is….

·       Productive efficiency because the firm is producing at AC’s lowest point (Q2). The firm is producing at its cost minimising point. Resources are used efficiently.

·       Allocative efficiency because firms are allocating the same amount of extra cost (MC) to customers as customers are allocating extra revenue to firms (P). Therefore P=MC, so it is allocatively efficient.

A perfectly competitive market is the only type of market structure where it is possible to be both allocatively and productively efficient.

This model of a perfectly competitive market is a theoretical extreme and is used to judge how closely real world industries approximate to this even if they are not truly competitive. This model, although unrealistic, holds the strong argument that resources are allocated efficiently and firms make beneficial exchanges which enable it to be efficient. The model provides a benchmark in which imperfectly competitive markets can be compared and contrasted.