How Do Infrastructure and Innovation Raise Productivity?
Supply-side policies
What you will learn
- Public support can remove bottlenecks and encourage useful knowledge creation.
- Apply the model to an original scenario and justify its limits.
Essential definitions
- Research and development
- Activity that generates new knowledge, products or production methods.
- Infrastructure
- Physical and organizational systems supporting economic activity.
- Industrial policy
- Government measures supporting selected industries, activities or capabilities.
Remove a practical production bottleneck
Infrastructure includes transport, power, water and digital networks. Suppose unreliable internet prevents local firms from selling online. A dependable broadband network can cut transaction costs and connect them to customers, making private investment more worthwhile. A large construction budget alone does not establish this benefit.
Maintenance and access matter. A bridge with little useful traffic or a network people cannot afford may deliver poor returns. Not every infrastructure service is a pure public good: tolls can exclude users and congestion makes one person's use affect another's. Network benefits, external benefits, access or natural monopoly may still justify public action.
Encourage useful innovation
Research creates new knowledge, but innovators may not capture all its benefits when other firms learn from it. Private incentives can therefore produce less research than is socially desirable. Grants, public laboratories or carefully designed subsidies can support projects with these spillovers.
Results remain uncertain. A grant for research that would happen anyway adds little, and political influence can protect established firms. Industrial policy targets particular industries through finance, procurement, support or temporary protection. Learning and coordination problems can justify help, but require evidence, performance conditions and a credible end to unsuccessful support.
Connect the time horizons and diagrams
A broadband project first adds construction and equipment spending. Some purchases may be imports. Only after completion and effective use do faster connections raise productive capacity. On AD–AS, with real GDP horizontally and the price level vertically, show the initial AD effect separately from any later rightward LRAS or SRAS shift. Keynesian capacity moves right only with a genuine supply gain.
Digital skills, maintenance and competition may be needed for firms to use the network. Compare total costs, environmental effects, access and additional private investment. A project should address a demonstrated bottleneck or market failure rather than treating any favoured industry or new structure as evidence of successful supply policy.
Infrastructure and public-good characteristics
Excludability means users can be prevented from using a service; rivalry means one person’s use reduces what others can use. A toll road excludes non-payers and a crowded road delays other drivers. An empty road may be approximately non-rival, but roads are not all pure public goods. Network links, external benefits, monopoly power or access goals can still justify public involvement. Identify the actual problem before choosing how to finance the service.
Why is a congested toll road not a pure public good?
Charging a toll makes it excludable, and congestion makes use rival.
An additional driver can be prevented from entering and, when admitted, can impose delays on other users.
Potential growth and long-run supply
LRAS moves from Yp=100 to Yp=120. Holding AD P=180−0.8Y fixed, the long-run price level is 84 at exactly the new potential output. The adjusted SRAS₂ passes through that long-run equilibrium; the adjustment path is not instantaneous.
More or better factors, technology and stronger institutions increase sustainable capacity. LRAS moves right. The final long-run equilibrium is on the new LRAS, not beyond potential output.
How to draw it and model assumptions
- Draw vertical LRAS₁ and LRAS₂.
- Intersect each with AD to mark initial E1 and new E2 at their respective capacities.
- Distinguish higher capacity from a temporary movement toward existing capacity.
New-classical long run: flexible input prices and output at potential. AD is held fixed to isolate the supply change; actual growth also depends on demand.
Demand management: fiscal and monetary policy
AD: P = 180 − 0.8Y. SRAS: P = 20 + 0.8Y. E2: Y=100, P=100. The final equilibrium closes the initial gap at Yp=100.
Expansionary monetary or fiscal policy raises spending and AD; contractionary policy lowers it. Closing a recessionary gap can raise output and employment, while closing an inflationary gap restrains price pressure.
How to draw it and model assumptions
- Select the initial recessionary or inflationary position.
- Shift AD toward the intersection of SRAS and LRAS.
- Mark initial E1 and final E2; compare the price level and real output at these intersections.
Short-run upward SRAS; potential output fixed. Policy transmission, confidence, import leakages and time lags determine the size of the actual AD shift.
Long-term shifts of Keynesian AS
Capacity rises from 120 to 144. AD remains P = 180 − 0.8Y. Initially Y=108.33, P=93.33; after the capacity change Y=119.39, P=84.49. On the rising segment AS₂ is P = Y/1.2 − 15.
Investment in productive capacity moves the rising and full-capacity portions of Keynesian AS right. At a given level of AD, output can be higher and price pressure lower; in a deep recession an increase in capacity alone may leave actual output unchanged.
How to draw it and model assumptions
- Draw the initial three-section AS curve.
- Move the bottleneck and vertical capacity sections right to show more capacity.
- Keep AD fixed and compare initial E1 with new E2.
Fixed AD, hypothetical capacity expansion with the flat-section price floor unchanged. Idle resources and sticky input prices persist in the low-output segment.
Apply and evaluate
- Infrastructure and innovation require complementary skills and maintenance; project selection and accountability govern returns.
Common misconceptions
- Targeting an industry does not prove that government has identified a market failure or a viable long-run activity.
Knowledge check
Why might private firms underinvest in research?
Real-world application
Funding workforce skills
6 April 2017: The UK government launched its apprenticeship levy on 6 April 2017 to help fund apprenticeship training.
Model application: relevant training may raise worker productivity and reduce skills mismatch, expanding productive capacity over time. Evaluate training quality, employer participation, time lags and who bears the financing cost. An announced programme is evidence of a policy intervention, not proof that its intended productivity gains occurred.
UK government, New levy to double annual investment in home-grown skills ↗Historical evidence checked 9 October 2026. The model interpretation is an original teaching application.
What to remember
Public support can remove bottlenecks and encourage useful knowledge creation. Benefits require sound project selection, complementary skills and maintenance, and must be distinguished from the initial demand boost.
Completion is your own reflection on learning, not a test score. Syllabus references: 3.7.07, 3.7.08, 3.7.09.
Sources and applications
Lessons in this section
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