6.2 Subsidy and Market Failure Flashcards
Draw the diagram
What is a subsidy used for in solving positive externality in consumption/merit good market failure?
A subsidy such as public transport, solar panel, vaccination, electric car, gym/leisure centre and museum subsidies will reduce the costs of production for firms shifting the MPC curve downwards from MPC to MPC+sub. The price decreases in the market from P1 to P2 and due to the law of demand, consumption is encouraged, increasing quantity from Q1 to Q, the socially optimum level of output. The under consumption and under production issues are fully solved. There is no longer a misallocation of resources with resources allocated efficiently at Q. Welfare is now maximised due to this intervention.
How does a subsidy solve positive externality in production market failure?
A subsidy such as in work training or R&D subsidies will reduce the costs of production for firms shifting the MPC curve downwards from MPC to MPC+sub, equal to MSC. The price decreases in the market from P1 to P* and quantity increases from Q1 to Q, the socially optimum level of output. The under production and under consumption issues are fully solved. There is no longer a misallocation of resources with resources allocated efficiently at Q. Welfare is now maximised due to this intervention.
Subsidies are very expensive to implement
What are the potential drawbacks of implementing subsidies to solve market failure?
Cons/Evaluation
- Subsidies are very expensive to implement. This is because all firms in a given industry must be eligible for the subsidy to prevent discrimination and unfair competitive advantages. There is a substantial opportunity cost involved therefore as this money needs to be generated from somewhere if no surplus tax revenue exists.
- Perhaps cuts will be made to education, public transport or health budgets worsening market failures in these areas. Maybe welfare spending will be cut or regressive taxes rise in the future burdening the poor and widening income inequality. These are difficulties the government faces if borrowing money is the only way to fund this subsidy. If the cost of the subsidy outweighs the gains in welfare, there will be government failure and a worsening of the misallocation of resources.
Con: governments can’t control how the subsidy is spent by firms
Cons/Evaluation
Government failure is guaranteed if the government cannot control how the subsidy is spent by firms. If firms uses the subsidy for reasons opposed to its intention for example to deleverage (pay off debts), increase the salaries of their staff, save in a bank or increase the dividends it pays to shareholders (unintended consequences), the financial costs of intervention will outweigh the benefits. The subsidy may also promote wastefulness, inefficiency and subsidy dependency overtime by the producers who receive it, where the subsidy is used to cover costs of production that are higher than what they should be. This is a large risk if the value of the subsidy is high increasing government costs over time and the burden on future tax payers.
What are the risks of setting the subsidy too low or too high?
Cons/Evaluation
Knowing the correct level of subsidy to set is extremely difficult for the government. This is because putting an accurate value on the positive externalities generated is highly complex in reality. There are Ways this can be done but not perfectly. As a consequence, the subsidy might be set too low where the price decrease is not large enough to increase quantity to the socially optimum level of output. If the subsidy is set too high the unintended consequences mentioned above are much more likely to occur leading to government failure where the costs of intervention outweigh the benefits.
Con: Effectiveness of the subsidy is PED is inelastic
Cons/Evaluation
If demand for the good or service is price inelastic, the majority of the subsidy will be passed on to the consumer via lower prices with there being a substantially larger decrease in price than increase in quantity. Whilst this is good news for consumers who purchase the good or service it will not increase quantity by enough to fully solve the market failure. Take public transport for example; if public transportation is cheaper due to subsidies given to providers, consumers will not necessarily respond because there are non-price demand factors that dominate the reduction in price. Perhaps consumers do not like the inflexibility, poor quality or unreliability of public transport hence do not use it even if fares are cheaper. Those who use it are most likely reliant on it to get to work and are therefore not going to consume more of it if fares are cut. Therefore an under consumption can remain with the market failure not fully solved.
How does the subsidization of a necessity like education and healthcare affect consumers?
Cons/Evaluation
If the good or service being subsidised is a necessity such as education and healthcare, prices falling could help affordability and improve equitable outcomes where exclusion reduces and consumers are able to now purchase goods and services improving their living standards significantly. However, though there is a short term benefit to consumers in the form of lower prices, they may significantly lose out in the long term having to pay for the financing of this subsidy via higher taxes. If regressive taxes increase in the future to pay off this subsidy, the burden on the poor will be greater widening income inequality.
