Supply-side policies and their impact on businesses: formula sheet

Key formulas

Aggregate demand identity

AD = C + I + G + (X − M)

Demand-side policies work by changing one or more of these components. Supply-side policies do not directly target them.

Effect of supply-side policy on the LRAS

Successful supply-side policy → LRAS shifts right → potential output rises

Draw the shift as a move from LRAS1 to LRAS2 and label real GDP on the horizontal axis and price level on the vertical.

Productivity

Labour productivity = Output ÷ Number of workers (or hours worked)

Many supply-side policies, such as training, aim to raise this.

Growth in potential output

Growth in potential output depends on growth in the quantity and quality of factors of production, and on technology

Use this to link each policy to a factor of production.

Aim of the policy

Policy → better incentives and competition → lower costs / higher productivity → LRAS shifts right

Use this chain in every answer. Each link is a point you can develop.

Labour supply response to a tax cut

Income effect vs substitution effect

A higher take-home wage makes leisure relatively costlier (substitution effect, more work). But people may feel richer and work less (income effect). The net effect is uncertain.

Effect on the economy

Rightward shift of LRAS: higher potential output, lower price level at a given AD

Draw it with real GDP on the horizontal axis and price level on the vertical axis.

Percentage change in tax revenue

New revenue = new rate × new tax base

A tax cut lowers revenue only if the base does not grow enough to offset it. Do not assume it always pays for itself.

Labour productivity

Labour productivity = Output ÷ Number of workers (or hours worked)

Human capital investment aims to raise this ratio. Use hours worked if the question gives hours.

Percentage change

% change = (New − Old) ÷ Old × 100

Use this to measure productivity growth or the rise in potential output.

Unit labour cost

Unit labour cost = Total labour cost ÷ Output

If productivity rises faster than wages, unit labour cost falls and competitiveness improves.

Effect on LRAS

Interventionist policy → ↑ quantity or quality of factors → LRAS shifts right → ↑ potential output

This is the chain of reasoning to state in every answer. It is a logical rule, not a numerical formula.

Unit labour cost

Unit labour cost = total labour cost ÷ output

Equivalent to wage per worker ÷ output per worker. Productivity gains lower it if wages do not rise as fast.

Labour productivity

Labour productivity = output ÷ number of workers (or hours worked)

Training, capital and technology raise it. Use it to show why costs per unit fall.

Effect on unit cost

Change in unit labour cost ≈ % change in wages − % change in productivity

An approximation for small changes. If productivity grows faster than wages, unit cost falls.

Policy effect on AS

Supply-side policy → LRAS shifts right → higher potential output and lower price level (other things equal)

A rule of reasoning, not a numerical formula. State that other things are held equal.

Quick revision

• Supply-side policies aim to increase potential output and shift long-run aggregate supply to the right.
• They work on productivity, costs and incentives, not on total spending.
• Market-based policies free markets: tax cuts, deregulation, privatisation, labour market reform, trade liberalisation, promoting competition.
• Interventionist policies use government action: education and training, infrastructure, R&D support, regional and small business support.
• Interventionist policies often rest on a market failure argument, such as under-provision of public goods or positive externalities.
• Supply-side effects usually take time, so benefits come with a lag.
• Lower taxes can improve incentives but may reduce government revenue and widen inequality.
• Privatisation may raise efficiency, but it can create private monopolies that need regulation.
• For businesses, the gains are lower costs, better skills, better infrastructure and more investment.
• For businesses, the risks are tougher competition, policy uncertainty and compliance changes.
• In evaluation, always weigh benefits against costs, time scale and who gains or loses.

Common mistakes

• Saying supply-side policies shift the AD curve. Fix: Supply-side policies target LRAS. Any effect on AD is secondary, for example through higher incomes.
• Treating a tax cut as always supply-side. Fix: Ask the purpose. A tax cut to raise work incentives or investment is supply-side. A tax cut to boost spending now is demand-side.
• Treating supply-side policies as demand management. Fix: Focus on the incentive and productivity effect. Mention any AD effect as a side effect, then return to the LRAS shift.
• Saying a tax cut always raises work effort. Fix: Mention both the substitution and income effects and say the net result is uncertain.
• Calling tax cuts or deregulation interventionist policies. Fix: Ask whether the government is spending or directing resources (interventionist) or removing barriers and increasing competition (market-based).
• Saying education spending shifts AD only. Fix: Say spending raises AD in the short run, but the main aim is to raise productive capacity and shift LRAS right in the long run.
• Confusing supply-side policies with demand-side policies such as lower interest rates or higher government spending. Fix: Ask whether the policy mainly raises productive capacity over time (supply-side) or mainly raises spending (demand-side). Say which effect you are discussing.
• Claiming the effect is immediate. Fix: Always mention time lags, especially for interventionist policies. Say whether the lag is short or long and why.

Exam tips

• Always say what the policy does to LRAS. Examiners look for the words 'shifts LRAS to the right' and 'potential output'.
• In comparison questions, use three headings in your answer: target (AD or LRAS), time horizon and typical tools.
• Use a labelled diagram whenever the question mentions 'illustrate', 'show' or 'explain how'. Label both curves and both equilibria.
• In multiple-choice questions, check the purpose of tax and spending measures. The same tool can be demand-side or supply-side.
• In longer answers, add one limit such as time lag, cost or uncertain results. It often earns the evaluation marks.
• For 'evaluate' or 'discuss' questions, give both sides and a final judgement. Marks are lost for one-sided lists.
• Always connect the policy to LRAS and to costs for businesses. Examiners look for that link.
• In MCQs, watch for options that claim effects are immediate, certain or demand-driven. They are usually wrong.