Introduction to Unit 3 - Supply Side Economic Growth and Applications

Let us quickly review some key points from section 2, Comparative Advantage and Trade.

• We constructed a simple model of an open economy.
  
• For two goods and two countries we determined that each country should specialize in the production of the good in which they have a comparative advantage. In this model, comparative advantage implies that each country should devote all of its productive resources to making the good in which they have a comparative advantage.
  
• With the terms of trade established, free trade allows each country to move from their PPF to their consumption possibilities frontier where overall national welfare has increased. Specialization and trade creates a higher living standard than possible in a closed system.
  
• In other words, for a fixed amount of resources, specialization puts productive inputs towards their best possible use and trade allows for the exchange of goods.
  

In this section we discuss the concept of supply side economic growth and then take a look at some specific applications that will help us to better understand the PPF and comparative advantage.

Supply side economic growth refers to the annual increase in a nation's productive capacity. It is represented by an outward expansion of a country's production possibilities frontier. As the inputs used in production and technology improve, a nation's productive capacity increases (thus shifting the PPF to the right). As long as inputs are used fully and efficiently, actual output increases along with the PPF. Higher levels of output lead to greater amounts of consumption of goods and services and higher living standards.

Consider the United States where annual supply side economic growth is estimated to approximate about 2.5% annually. Net increases in the labor force approximate about 1% a year. Improvements in technology are captured in better capital and increases in the capital stock. The reported measure for the enhancements to production resulting from improved and more capital is known as worker productivity. Gains in worker productivity represent higher output per worker hour, day, week, etc. If workers have more and better capital to work with their output increases. Just think if you suddenly receive a brand new computer with a faster modem, better software, and increased processing power, you will probably get more done with your time spent on the PC. Increases in worker productivity in the U.S. average about 1.5% a year. Summing up the annual increase in the labor force (1%) plus improvements in worker productivity (1.5%) leads to our average annual supply side economic growth of 2.5%.

Throughout much of the course we will also look at fiscal and monetary policies. Fiscal policy refers to changes in tax rates and government spending. Monetary policy is carried out by the Federal Reserve Board and results in changes in interest rates. Fiscal and monetary policies change the demand side of the economy, or where the economy is at in relation to its productive capacity. These policies can help locate the economy at a point along its PPF. In contrast, supply side growth refers to the rate of expansion of the PPF.

In summary:

Supply side economic growth determines the rate of expansion of a nation's productive capacity and its PPF, but not where the economy is located in relation to the PPF.

Fiscal and monetary policies have little or no influence on the rate of supply side economic growth, but determine where the economy is in relation to its PPF. For example, if the economy is at a point located inside the PPF, expansionary fiscal and monetary policies can guide to a point along its PPF.

The applications that we will cover will include:

• Given our understanding of supply side economics, who are the supply-siders and what do they believe? Supply-side economists emphasize the incentive effects to work harder when taxes are reduced. Greater work effort translates into enhanced gains in worker productivity and an increased pace of supply side economic growth. We will take a look at President Reagan's economic record (since he was a believer in supply-side tax policies) to see if there was any acceleration in economic growth.
  
• We will take a look at the United Nation's Conferences on Population and Women to better understand the global issue of population growth and promoting increased opportunities for women throughout the world.
  
• A major corporation, Cisco Systems, will be discussed to better understand the applications of specialization and comparative advantage.
  
• Exchange rates will be introduced and how changes in them affect trade between countries. An increase or decrease in the value of a currency in terms of another alters the relative prices of imports and exports.

LINK TO MAIN SECTION OF UNIT 3 - Supply Side Economic Growth and Applications