1.4.1 Subsidies

Question 1

Define a subsidy

Answer 1

Any form of government support - financial or otherwise - offered to producers and (occasionally) consumers

Question 2

Suggest the market failure that subsidies could be used to correct

Answer 2

Positive externality of consumption leading to underconsumption.

Question 3

How do subsidies correct market failure

Answer 3

Lowers cost of production, incentivising producers to produce more, correcting for under-provision of the good as more resources are now allocated to the good

Question 4

What is the effect of a subsidy on the supply curve

Answer 4

Shifts outwards as it lowers the cost of production

Question 5

How do subsidies maximise social welfare

Answer 5

The market now produces at the output that best allocates resources aka social optimum (MSC=MSB) rather than MPC=MPB

Question 6

what are the pros of subsidies

Answer 6

• raises output of merit goods
• increases consumer surplus
• increases competition in the long term
• internalise external benefit

Question 7

how do subsidies raise output of merit goods

Answer 7

• subsidies reduce the cost of production to the producer
• therefore they supply more, raising output of a merit good to the socially desirable level

Question 8

how do subsidies increase consumer surplus

Answer 8

• reduced price for the consumer, making the product more affordable
• this increases consumer surplus as the difference between the amount the consumer is willing and able to pay and being charged is widening

Question 9

how do subsidies increase competition in the long-term

Answer 9

• in the long term, they may encourage producers into the market, increasing competition
• this may further benefit the consumer with lower prices

Question 10

how do subsidies internalise the external benefits

Answer 10

subsidies work with market forces and internalise the external benefits of the product subsidies
this enables a socially optimum level of output to be reached

Question 11

what are the cons of subsidies

Answer 11

• hard to decide the correct size of the subsidy
• opportunity cost
• dependency could arise
• may have an impact on other market that is not always desirable

Question 12

why is it hard to decide the correct size of the subsidy

Answer 12

hard to decide the correct size in order to bring about the socially optimum level of output once positive externalities are considered (due to complexity in shadow pricing)

Question 13

how do subsidies cause opportunity cost

Answer 13

subsidies are a clear cost to the government
there is an opportunity cost as taxpayer funds could have been used in a different way

Question 14

how can subsidies lead to dependency

Answer 14

• subsidies can lead to greater inefficiencies on behalf of the producer as any rise in costs can be offset by the subsidy, leaving less of an incentive to lower costs
• this can lead to dependency and damages the long-term competitiveness of the industry

Question 15

what does the effectiveness of subsidies depend on

Answer 15

• PED
• size of subsidy
• ability of firms to increase supply
• accuracy of shadow pricing

Question 16

how do subsidies depend on PED

Answer 16

more effective is product is price elastic, as consumers are more responsive to changes in price so more likely to increase demand

Question 17

how do subsidies depend on accuracy of shadow pricing

Answer 17

if subsidy does not correctly value the positive externality then the product may be over/under subsidised