3.7.2 Market-based policies Notes

Market-based supply-side policies aim to improve economic efficiency through reduced government intervention and enhanced market mechanisms.

Policies to encourage competition

1. Deregulation removes unnecessary government controls and bureaucratic procedures from private sector activities.
2. Privatisation transfers state-owned enterprises to private ownership to improve efficiency and service quality.
3. Trade liberalisation reduces international trade barriers to promote global competition.
4. Anti-monopoly regulation prevents market domination and ensures competitive markets.

Labour Market Policies

1. Reducing trade union power allows wages to respond more flexibly to market conditions.
2. Reducing unemployment benefits encourages faster return to work through stricter eligibility requirements.
3. Abolishing minimum wages enables market-determined wage rates to clear labour markets efficiently.

The diagram below illustrates how minimum wage policies can create labour market distortions:

1. Government-imposed minimum wage ($W_{min}$) sits above the market equilibrium wage ($W_e$).
2. At $W_{min}$, the quantity of labor supplied ($Q_s$) exceeds quantity demanded ($Q_d$).
3. This difference ($Q_s - Q_d$) represents unemployment created by the wage floor (minimum wage).
4. Removing minimum wage allows the wage rate to fall to $W_e$.
5. This lower wage costs encourage firms to hire more workers.
6. This causes the market to reach equilibrium with higher employment ($Q_e$).
7. The increased employment contributes to higher productive capacity.
8. Furthermore, lower labor costs help reduce overall production costs.

Incentive-Related Policies

1. Personal income tax cuts increase workers' take-home pay and motivation to work longer hours.
2. Business tax reductions provide firms with more resources for investment and innovation.
3. Lower capital gains tax encourages greater savings and investment in productive assets.

All these market-based supply-side policies work together to enhance the economy's productive capacity. Their combined effect can be illustrated using the AD/AS model:

The diagram above illustrates how supply-side policies affect the economy:

1. The initial equilibrium occurs at price level $P_1$ and output $Y_1$.
2. When market-based policies are implemented, it reduce costs of production across the economy.
3. The lower costs shift LRAS rightward from $LRAS_1$ to $LRAS_2$ / $AS_1$ to $AS_2$.
4. Firms can now produce more output at each price level.
5. This forms a new equilibrium at a lower price level $P_2$ and higher output $Y_2$.
6. Therefore, the economy achieves both lower inflation and higher real GDP.
7. Hence, potential output increases without creating inflationary pressure.