Mod003327 Economics For Managers- Theory Assessment Answers
The answers to the questions must be supported by academic theories and concepts and the paper must comply with the academic essay format and the Harvard referencing guidelines. The discussion must not be just descriptive in nature; it should provide clear evidence of understanding of supply side policies.There are a range of diagrams available for students to use and part of your answer must be predicated upon them and the explanation of them. You are not expected to describe how basic supply and demand work. All diagrams must be referenced. Failure to do so will mean you will fail to achieve all of the marks available.
Answer:
The situation where total output of an economy increases over time captured by its gross domestic product. In other way, when the economy can produce more of all goods using its scarce resources then the economy is to be growing. A set of policies can be adapted to foster .The policies are broadly categorized as demand side policies and supply side policies. The demand side policies aim to achieve a high growth rate by increasing aggregate demand. The objective of an increased aggregate demand can be accomplished by either fiscal stimulus or monetary injection.
The supply side policies on the other hand work with the tool of aggregate supply. The main idea behind supply side stimulus is that supply of goods or production is the driving factor for determining growth. Supply side economies stands in sharp contrast to Keynesian theory or other advocators that favored demand side policies for economic recovery from a phase of recession. Prior to supply side policies, all the policies for combating recession were demand centered. It was widely believed that raising consumer demand foster productive activity and bring economic growth. In contrast to this, the advocates of supply side policies claim that suppliers and their capacity to produces goods and services in turn prepares the path.
The paper discusses supply side policies that can be used to foster economic growth in UK. In UK the traditional demand side policies have failed to achieve desired growth rates and therefore alternative strategy relying on supply side economics.
There are different theories of economic growth identifying different driving factors for economic growth. Following are the main theories of economic growth.
Mercantilism
The mercantilist theory of economic growth originated at the beginning of industrial revolution. This is not actually a theory of economic growth. It argues that an economy is better off by accumulation of precious metal and an expansion of export (Weingast 2017).
Classical theory of economic growth
The main idea of classical growth model is to bring a stationary state for the economy from its progressive state. The advocators of classical growth theory are Adam Smith, David Ricardo, T.R Malthus, J.S Mill and others (Lewis 2013). The classical growth theory is based on the following assumption
- As per classical theory, progressive state of the economy is characterized as high capital accumulation leading to an increase in output by raising productivity of labor input. The accumulation level in turn is determined by the profit level.
- There are two determinants of profit: total labor product and wage levels. This in turn depends on marginal product of labor.
- Technology of production and stock of capital determine labor productivity.
- The short run market wage can lie above the level of subsistence giving a stimulus to population growth. Because of the increasing population long run wage approaches to the subsistence level. Once wage reaches to subsistence level population growth tend to cease (Myrdal 2017).
In the above figure OP curve shows total product after deduction of rent. The straight-line OS shows total wage payment given only subsistence wages are just paid always. An increase in population from O to OR1 raises total product after rent payment by R1P1. However, an equal increase in working population from OV to OR raises total product by only a small amount.
When population is OR1, then a profit of amount S1P1 is realized obtained as a difference between total product and a subsistence wage payment of R1S1. This profit reflects capital accumulation. The accumulated capital pushes up wage resulted from an increased labor demand. With economic expansion population increases and so is the wage bill. This continues unless wage reaches to the subsistence level indicated as W. This is obtained as an intersection of OP and OS curve. At this point there is no room for further capital accumulation and hence a state of classical stationarity is obtained.
Neo classical growth theory
Neo Classical Economists Hick, Mrs. Joan Robinson, J.E. Meade, Prof Swan and Robert Solow developed their individual growth model. These theories together called Neo classical theory of economic growth (Meade 2013). This discusses ideas of neo classical theory and is a reaction to Harrod Domar model.
The Harrod Domar model suggests that economy always tends towards instability. According to neo classical model the instability will end up when there is flexible capital output ratio.
The formal neo classical model has a set of assumption. It assumes that the economy experiences constant return to scale in the long run where no technical progress can take place. In this model substitutability is assumed between labor and capital and factors get payment equal to their marginal product.
Once the economic growth rate exceeds its natural rate the ceiling of full employment is crossed. From this point labor saving technology begins to be used leading to an increase in capital output ratio. This dampens the growth rate until it reaches to its natural rate (Peet and Hartwick 2015).
When there is a change in incremental capital output ratio (v) and saving and incremental capital output ratio (s/v) then neither Harrodian instability nor Raisor’s Edge will persist and the economy can achieve a steady state equilibrium.
As per neo classical model at the full employment level saving equals investment and net investment equals level of capita stock.
In the above figure sQ/K denotes the capital growth which is a function of output capital ratio and having a slope equals s. n is the labor schedule. q1 is the output curve passing between growth of labor and growth of capital schedule. E is the equilibrium point of stable equilibrium. Before E output growth exceeds capital growth while after E capital growth is higher than output growth.
New Economic Growth Theories
The advocates of new growth theories, Robert Lucas and Paul Romer had placed stress on formation of human capital to achieve economic growth. The theory explains how higher knowledge, education base and training help to raise the rate of technological advancement (Bardhan 2016). The model emphasizes on raising labor and capital productivity, increased benefits of spill over effect from a broad knowledge based economy and greater emphasis on a free market economy.Supply side policies aim to raise productivity of the economy causing a rightward shift of the aggregate supply curve.
In the short run policies to boost productivity increases aggregate supply from AS to AS1. Given aggregate demand curve this raises the aggregate output from Y* to Y1 and causes a decline in price level from P* to P1.
In the long run aggregate supply curve becomes a vertical straight line. Demand sided policies that shift the aggregate demand curve to the right fails to increase output and only increases price level. In this situation, an increase in aggregate supply offset the price increase and increases aggregate output keeping the price level constant at P1
Two major school of thoughts advocating supply side policies are
- Free market supply side policies
- Interventionist supply side policies
The free market supply side policies refer to policies that promote competition and competitiveness. This involve policies of privatization, lowering tax rates, deregulation and reducing power of trade unions (Canto, Joines and Laffer 2014).
Privatization
Privatization refers to the policy of selling government owned assets to private sector. It is believed that private sector run by profit motive is more efficient in directing business activity that state-owned enterprises.
Lowering tax rates
Taxes are compulsory payments to the government. When a larger share if income is taxed then it discourages people to work. A lower tax rate on the other hand encourages people to work hard as a greater share of income can be enjoyed. The increased work effort in turn increases labor productivity and raise output (Burda and Wyplosz 2013). A reduction in the corporate tax rate incentivizes business firm to invest more to earn a greater profit.
Deregulation
Deregulation means reducing entry barriers in the market to boost competition. Competition among firms increase efficiency and provides a better quality of goods or services.
Reducing power of trade unions
Trade union often calls strikes to fulfill their claims. The strikes hampers production and output. Reducing power of trade union prevents output loss because of strikes. Trade unions claim for high wage which crate unemployment in the labor market (Mankiw 2014). Therefore, lowering bargaining power of the trade unions reduces unemployment resulted from a high real wage.
Interventionist supply side policies
The supporters of interventionists supply side policies suggest government intervention is needed where free market fails to perform efficiently. There are certain areas where private investors do not participate because of low profitability. This calls for government intervention (Heijdra 2017). Following are some examples of interventionist policies.
Increased training and education
Education improves productivity of labor by enhancing skills. Education entails positive externality and hence is always underproduced in a free market situation (Xiao 2016). Therefore, government need to intervene by subsidizing training and education.
Building infrastructure and improved transportation
In transportation market failure exists in the form of high pollution and congestion. Government expenditure in improving transportation helps to reduce congestion and correct market failure (Langdana 2016). An improved provision of transportation reduces cost and encourages private firms to invest.
Increasing housing supply
In the expensive areas building council homes increases mobility of workers as they can afford homes in these areas and can find better job opportunities. Firms suffering from a shortage of labor can have sufficient labor supply and produce a greater output.
Improved health care
Workers having a good health condition are more productive than those with ill health condition. Private health care centers are expensive, and workers cannot always afford health services in private centers. Government should provide healthcare services at an affordable price (Meyer 2012). Government also discourage unhealthy habit by taxing goods bad for health and subsidizing healthy habits.
Supply side policies in UK
The demand sided policies in UK fail to achieve a growth rate of the economy beyond long run trend growth rate and results in undesirable cyclical fluctuation. For example, in 1972 fiscal expansion was undertaken in the form of a large reduction in the tax rate. This though brings an economic boom but was also associated with a hike in inflation. This made the resulted growth unsustainable. The same thing happened in 1980s. During late 1980’s an expansionary fiscal and monetary policy were adapted by UK government. The high growth and inflation in the economy lead to recession in 1991-92 (Warren 2014). The failure of demand side policies to bring a sustainable growth makes the policymakers to think of alternative strategies focusing on supply side of the economy.
Followings are some of the supply side policies undertaken in UK.
Privatization
Major public utilities including water, gas and electricity were sold to private enterprises through extensive campaign on privatization. Competition has been encouraged in industries like telecommunication to reduce price and improve the quality of services. However, government faces difficulty in introducing competition in the water industry (Obinger, Schmitt and Zohlnhöfer 2014). Rail privatization is done successfully.
Lowered income tax
In 1980s UK government had cut income tax for well being of the society. The highest tax rate dropped from existing level of 60% to a new level of 40% (De Agostini, Hills and Sutherland 2014). To compensate the loss of revenue from a decline in income tax government has raised indirect taxes like VAT and others.
Lowering bargain power of trade unions
The government has made the operation of trade unions difficult through incorporation of strict laws to reduce the bargaining power of trade unions (Addison 2014).
Deregulation of financial market
Deregulation of financial markets is another step taken to improve supply side of the economics. For this, the government allowed different financial institution to act like banks and build many new institutions to provide mortgages (Moran 2015). This results in competition in the financial industry and reduces the borrowing cost.
Improving Supply side of the economy in UK
The following measures can be undertaken to improve the factor productivity and supply side of the economics
- Government can use the tax system to incentivize the factors and raise output instead of attempting to alter demand. This is often considered as central of supply side policies. The policy suggests reducing direct taxes such as income tax or corporation tax. A smaller income tax rate motivates exiting laborer to work harder and unemployed members to join jobs. A low corporation tax similarly motivates entrepreneur to increase production and raises national output.
- Other policies favoring supply side of the economy include enhancing competition in the labor market. This can be done by elimination of restrictive practices and relaxing rigidities in the labor market. UK has already made progress in reducing trade union power by limiting worker’s ability to go for a strike and enforcing confidential ballot for union members before strike action.
- Improvement of labor mobility has a positive influence on the productivity of labor and hence improve supply side performances.
- The supply side performance can be improved by human capital development. For this, training and education should be arranged to enhance skills, mobility and labor market flexibility. Expenditure on training and education tend to increase labor productivity. The UK government has recently taken this kind of supply side policy option (Denton, Forsyth and MacLennan 2017). Government can either directly spend money in training or education program attract private suppliers. The teaching standard can be monitored. The government can force to incorporate a component of skill development in formal education curriculum.
- To improve productive performance of the public sector a scheme of payment related to performance can be adapted.
- Government can boost local pay bargaining instead of central bargaining. The central pay scheme hardly reflects local scenario contributing to a decline in labor mobility.
Conclusion
The paper discusses applicability of supply side policies to attain economic growth in UK. There are different school of thoughts explaining economic growth in different ways. The classical economists define growth as a stationary state where only subsistence wage is earned and there is no room for additional capital accumulation. For neo classical economists’ stationarity is achieved where return of capital growth equals output growth. The new growth theory or endogenous growth theory is centered around technical innovation and human capital development. Supply side policies bring economic growth by increasing productive efficiency and national output.
There are two types of supply side policies- free market policies and interventionists policies. In UK supply side policies are undertaken in the form of privatization, deregulation, lowering tax rates and reducing power of trade unions. However, there are other supply side policies that can be taken to achieve the goal of a sustained economic growth.
References
Addison, J.T., 2014. The consequences of trade union power erosion. IZA World of Labor.
Bardhan, P., 2016. Endogenous Growth Theory to the Analysis of Development Problems: An. New Theories in Growth and Development, p.97.
Burda, M. and Wyplosz, C., 2013. Macroeconomics: a European text. Oxford university press.
Canto, V.A., Joines, D.H. and Laffer, A.B., 2014. Foundations of supply-side economics: Theory and evidence. Academic Press.
De Agostini, P., Hills, J. and Sutherland, H., 2014. Were we really all in it together? The distributional effects of the UK Coalition government’s tax-benefit policy changes. Social Policy in a cold climate Working Paper, 10.
Denton, G., Forsyth, M. and MacLennan, M., 2017. Economic planning and policies in Britain, France and Germany (Vol. 3). Routledge.
Fernández-Villaverde, J., Guerrón-Quintana, P. and Rubio-Ramírez, J.F., 2014. Supply-side policies and the zero lower bound. IMF Economic Review, 62(2), pp.248-260.
Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.
Langdana, F.K., 2016. The Supply-Side Model and the New Economy. In Macroeconomic Policy (pp. 233-270). Springer International Publishing.
Lewis, W.A., 2013. Theory of economic growth (Vol. 7). Routledge.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.
Meade, J.E., 2013. A Neo-Classical Theory of Economic Growth (Routledge Revivals). Routledge.
Meyer, L.H. ed., 2012. The supply-side effects of economic policy (Vol. 1). Springer Science & Business Media.
Moran, M., 2015. Politics and Governance in the UK. Palgrave Macmillan.
Myrdal, G., 2017. The political element in the development of economic theory. Routledge.
Obinger, H., Schmitt, C. and Zohlnhöfer, R., 2014. Partisan politics and privatization in OECD countries. Comparative Political Studies, 47(9), pp.1294-1323.
Peet, R. and Hartwick, E., 2015. Theories of development: Contentions, arguments, alternatives. Guilford Publications.
Warren, P., 2014. A review of demand-side management policy in the UK. Renewable and Sustainable Energy Reviews, 29, pp.941-951.
Weingast, B.R., 2017. War, Trade, and Mercantilism: Reconciling Adam Smith's Three Theories of the British Empire.
Xiao, L., 2016. Supply-side economics and supply-side structural reform from a global perspective. Scientific Development, 4.
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