Economics Model Essay 10

This question will be discussed in the ninth week of term 3 (JC2) in economics tuition.

Discuss whether increasing labour productivity in Singapore would be desirable for the economy. [25]

Answer

Introduction

Labour productivity refers to output per hour of labour. The question on whether increasing labour productivity in Singapore would be desirable for the economy can be discussed in terms of the effects on the balance of payments, national output and hence national income, unemployment, inflation and income equity.

Increase in National Output/National Income

Increasing labour productivity in Singapore will lead to an increase in aggregate supply resulting in an increase in national output and hence national income. Aggregate supply is the total supply of goods and services in the economy over a period of time and is determined by the production capacity and the cost of production in the economy. When labour productivity in Singapore rises, firms will need a smaller amount of labour to produce any given amount of output. Therefore, the cost of production in the economy will fall. Furthermore, to increase labour productivity in the economy, the government may increase the skills and knowledge of labour or the efficiency of capital in the economy. If this happens, the production capacity in the economy will increase. A fall in the cost of production and an increase in the production capacity in the economy will lead to an increase in aggregate supply resulting in an increase in national output. When firms increase production, they will employ more factor inputs from households and hence will pay them more factor income which will lead to an increase in national income.

In the above diagram, an increase in aggregate supply (AS) from AS0 to AS1 leads to an increase in national output and hence national income (Y) from Y0 to Y1.

Fall in Unemployment

The increase in national output due to the increase in aggregate supply in Singapore will lead to a rise in the demand for labour in the economy resulting in a fall in unemployment.

Fall in Inflation

Assuming aggregate demand in Singapore is rising which is the normal state of the economy, an increase in aggregate supply will lead to a smaller rise in the general price level resulting in lower inflation.

Improvement in the Balance of Payments

When labour productivity in Singapore rises, the balance of payments may improve. The balance of payments is a record of all the transactions between the residents of the economy and the rest of the world over a period of time and is made up of the current account and the capital and financial account. Lower inflation in Singapore may make Singapore’s goods and services relatively cheaper than foreign goods and services. If this happens, net exports will rise which will lead to an improvement in the current account and hence the balance of payments.

Increase in National Output/National Income and Fall in Unemployment

Increasing labour productivity in Singapore may lead to an increase in aggregate demand resulting in an increase in national output and hence national income and a fall in unemployment. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. To increase the skills and knowledge of labour in Singapore, the government may increase expenditure on education and training directly. For example, it has set up the Institute of Technical Education, polytechnics and Continuing Education and Training campuses to provide education and training. Furthermore, the government may increase expenditure on research and development directly to increase the efficiency of capital in the economy. For example, it has set up the Biomedical Research Council (BMRC) and the Science and Engineering Research Council (SERC) under the Agency for Science, Technology and Research (A*STAR) to engage in research and development. If these happen, government expenditure on goods and services will increase. To increase the efficiency of capital in the economy, the government may incentivise firms to adopt better production technologies through subsidies or tax incentives. For example, it introduced the Productivity and Innovation Credit (PIC) scheme which provided subsidies and tax deductions for research and development expenditures that led to improved production methods. If this happens, investment expenditure will increase. Furthermore, when the cost of production in the economy falls due to an increase in the skills and knowledge of labour and hence labour productivity in the economy, expected returns on planned investments will rise. When this happens, investment expenditure will increase. An increase in investment expenditure and government expenditure on goods and services will lead to an increase in aggregate demand resulting in an increase in national output and hence national income.

In the above diagram, an increase in aggregate demand (AD) from AD0 to AD1 leads to an increase in national output and hence national income (Y) from Y0 to Y1. When firms increase production in response to an increase in aggregate demand due to an increase in investment expenditure and government expenditure on goods and services, they will employ more factor inputs from households and hence will pay them more factor income. When households’ income rises, they will increase consumption expenditure which will lead to a further increase in aggregate demand and this will induce firms to further increase production. When this happens, firms will employ even more factor inputs from households and hence will pay them even more factor income. The further increase in households’ income will induce them to further increase consumption expenditure resulting in a further increase in aggregate demand. Therefore, the initial increase in aggregate demand due to the increase in investment expenditure and government expenditure on goods and services will lead to increases in consumption expenditure and hence further increases in aggregate demand resulting in a larger increase in national output and hence national income. This is commonly known as the multiplier effect. An increase in national output will lead to an increase in the demand for labour in the economy resulting in a fall in unemployment.

Improvement in Income Equity

Increasing labour productivity in Singapore may lead to an improvement in income equity. If the productivity of low-skilled workers in Singapore rises, firms that employ these workers will experience a fall in their costs of production. When this happens, they will be able to increase the wages of the workers without suffering a fall in profitability. If the wages of low-skilled workers rise, income equity will improve, assuming the wages of high-skilled workers do not rise by the same or larger proportion.

Detrimental Effects

Although increasing labour productivity in Singapore will bring about beneficial effects to the Singapore economy, it will also bring about detrimental effects. As a rise in labour productivity in Singapore will enable firms to employ a smaller amount of labour to produce any given amount of output, it may lead to a fall in the demand for labour resulting in a rise in unemployment. The increase in aggregate demand in Singapore will lead to a rise in the general price level resulting in higher inflation. An increase in aggregate demand in Singapore will lead to a shortage of goods and services resulting in a rise in the general price level. Furthermore, when aggregate demand in Singapore rises which will induce firms to increase production, the increase in the demand for factor inputs in the economy will lead to a rise in the prices. When this happens, the cost of production in the economy will rise which will induce firms to increase prices to maintain profitability resulting in a rise in the general price level. This is undesirable particularly if the economy is overheating where aggregate demand is rising rapidly relative to aggregate supply resulting in high inflationary pressures. When national income rises, imports will rise. Furthermore, the rise in the general price level due to the increase in aggregate demand may make Singapore’s goods and services relatively more expensive than foreign goods and services which will lead to a decrease in net exports. If these happen, the current account and hence the balance of payments will deteriorate, assuming the demand for exports is price elastic. As Singapore is a small economy that is highly dependent on external demand with the domestic exports accounting for a large proportion of the aggregate demand, an increase in investment expenditure and government expenditure on goods and services may not lead to a significant increase in aggregate demand resulting in an insignificant increase in national output and hence national income. Education and training will increase the skills and knowledge of labour and research and development will increase the efficiency of capital only in the long run. Therefore, they will not increase labour productivity in the economy in the short run. To induce firms to increase labour productivity, the government may tighten restrictions on foreign workers to increase their costs of production. If this happens, the cost of production in the economy will rise which will lead to a fall in expected returns on planned investments resulting in a decrease in investment expenditure. As a proportion of the decrease in investment expenditure will be foreign direct investment, the capital and financial account and hence the balance of payments will deteriorate. Tightening restrictions on foreign workers may lead to a decrease in the population resulting in a decrease in consumption expenditure. If consumption expenditure and investment expenditure fall, aggregate demand will fall which will lead to a decrease in national output and hence national income resulting in a rise in unemployment. A rise in the cost of production in the economy will also lead to a decrease in aggregate supply which will lead to a decrease in national output and hence national income resulting in a rise in unemployment. A decrease in aggregate supply will also lead to a shortage of goods and services resulting in a rise in the general price level and hence higher inflation, and if this makes Singapore’s goods and services relatively more expensive than foreign goods and services, net exports will fall which will lead to a deterioration in the current account and hence the balance of payments, assuming the demand for exports is price elastic. If the productivity of high-skilled workers rises, firms that employ these workers will experience a fall in their costs of production. When this happens, they will be able to increase the wages of the workers without suffering a fall in profitability. If the wages of high-skilled workers rise, income inequity will worsen, assuming the wages of low-skilled workers do not rise by the same or larger proportion.

Evaluation

In the final analysis, the Singapore government should restructure the economy from one which is labour-driven to one which is productivity-driven. This is not only appropriate but necessary for achieving sustainable economic growth. The labour-driven economic growth strategy requires the support of a loose foreign worker policy which will lead to rising population. However, as Singapore is a small country with a small land area of slightly over seven hundred square kilometres, rising population will exert a strain on the country’s infrastructure which may lead to problems such as severe traffic congestion, crowded public buses and trains and rapid rises in housing prices. Indeed, the rising population in Singapore was a major factor which led to the rapid rise in housing prices before the 2008-2009 Global Financial Crisis. Therefore, the labour-driven economic growth strategy is unsustainable in Singapore. In contrast, as the productivity-driven economic growth strategy will not lead to rising population, the small land area of Singapore is not a constraint for this strategy. However, due to the potentially limited effect of the policies for increasing labour productivity in the economy on aggregate demand in Singapore, the government should complement them with policies that will boost aggregate demand. This is to ensure that the increase in the production capacity in the economy is used by firms to produce more goods and services rather than lying idle. Given the high dependence of the Singapore economy on external demand, trade policy such as signing more free trade agreements to increase exports is the most effective policy to increase aggregate demand. Indeed, Singapore has signed over 20 free trade agreements to increase exports and foreign direct investments, which is the highest number in the world.

Author’s comments

Students simply need to explain whether increasing labour productivity in Singapore would be desirable for the economy in terms of the effects on the balance of payments, national income, unemployment, inflation and income equity. The question will be discussed at Economics Cafe in economics tuition at the end of Chapter 12 Macroeconomic Policies.

Students should understand although an increase in labour productivity in the economy will not lead to an increase in the production capacity in the economy, the measures that can be used to increase labour productivity in the economy may increase the production capacity in the economy. It is very important to discuss this in the essay.

In addition to the effects of increasing labour productivity in Singapore on the economy via the effect on aggregate supply, students should discuss the effects on the economy via the effect on aggregate demand.

Students should explain the multiplier effect as it is an important concept in the Singapore-Cambridge GCE ‘A’ Level Economics.

Students should understand that increasing labour productivity in the economy is one of the top macroeconomic priorities of the Singapore government.

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