Subsidy and market failure

Question 1

define subsidy?

Answer 1

money grant given to producers by the government to lower costs of production and encourage an increase in output.

Question 2

How would the positive externality look in consumption?

Answer 2

label the x-axis as quantity
label the y-axis as price
-draw a normal MSC=MPC curve pointing upwards
-draw a normal MSB curve downwards
-draw a normal MPB cuve downwards
-draw a parallel shift to the right where it will be MPC+sub
the new equilibrium point will be where p star=q star at MSC=MPC
-show how price lowers but quantity increases

Question 3

how does the subsidy work in consumption?

Answer 3

1. the subsidy will lower the cost of production for instance buses, rails, vaccinations, and solar panels are prime examples.
2. This will cause the marginal private cost curve to shift to the right
3. we will assume that subsidy is perfect where MPC will hit the MSB.

Question 4

What would the curve look like for positive externality in production with the help of subsidy?

Answer 4

label the x-axis as quantity
label the y-axis as price
-draw a normal MPB=MSB pointing downwards
-draw an MPC curve pointing upwards shifting to the right where now it will be MSC=MPC+sub
showing how prices have gone down to p star and an increase in quantity from q1 to q star.

Question 5

eval-is the subsidy too expensive to impose

Answer 5

if the money has been borrowed it can impact the poor the most, spending cuts can further burden the poor and it cuts education and healthcare

• could this money have been spent elsewhere more efficiently
• also the subsidy has to impact everyone working in the industry which can be expensive and time-consuming

Question 6

eval-setting the subsidy at the right level?

Answer 6

in theory, we assume that the gov has perfect info, however, we can argue that information gaps exist which means market failure will not be solved and hence not achieve the socially optimum level.
-because of the lack of info the gov may end up over-subsiding and some firms may become dependent where they will be sitting on top of all this money grant despite knowing that costs will be rising.

Question 7

eval-the subsidy could be used for other purposes?

Answer 7

instead of the producers using this money grant to lower prices via consumers, they can use it to pay off debt, save some of this subsidy in the market, or pay shareholders to keep them satisfied and increase the salary of workers.

Question 8

what happens if it’s price inelastic demand-eval?

Answer 8

it has to be price-elastic so that firms can boost the quantity
-also you can argue that through lowering costs e.g public transport it can encourage people to start using public transport rather than cars but again you can argue that despite costs being reduced not everyone will switch or people who already use buses and trains won’t consume more of it + using transport causes time delay and inflexibility.