Subsidies | Model Answer
A-level Economics
Evaluate the view that firms in industries such as cars and energy should operate without any financial assistance from the government.
My recommended time for you to complete this is about 30mins. If you can complete this question in 30 minutes and score high marks, you are in a very good position already. Some of you may need longer than 30 minutes to produce a good answer - if you need this long it is an indication that you are not ready for your exam and you likely run out of time in the real thing.
I have posted my answer at the bottom of the page. Remember in the real exam you will probably have extracts to use also. It is essential to quote from these extracts in the real test.
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MODEL ANSWER
DEFINITIONS
Subsidies can be defined as a payment from the government to a firm in order to encourage production of a good or service. Market failure is when the free market fails to allocate resources efficiently and as a result has failed to maximise social welfare.
Background knowledge to subsidies
Subsidies are a form of government intervention in a market in order to correct a potential market failure. If the government is considering subsidising a firm, then it is likely that the firm is under-providing the good/service. There could be positive externalities in consumption or possibly even production of the good. The way to correct the market failure would be for the market to result in a position with a higher provided quantity than before, at the socially optimal level (MSB = MSC). If the socially optimal quantity is different to where the free market provides (MPB = MPC) then the market would be failing without intervention.
The diagram above shows the effect of a subsidy on a market. Q2 is the socially optimal level and is hence the government’s target allocation for the market. The total subsidy paid by the government is P2P3 x Q2. The consumer benefit is the blue shaded area and the producer benefit of the subsidy is the purple shaded area.
Should car and energy firms operate without subsidies?
Cars and energy firms are responsible for many negative externalities from production of their goods/services. For example, the manufacture of a car would incur third party costs such as air pollution and hazardous waste as a result from the factory. When subsidising, governments need to consider the net social benefit of the intervention. If the production externalities bring about severe costs to society’s welfare that potentially outweighs benefits, the government should not subsidise at all. A more difficult example might be the production of electric cars. While electric cars bring about benefits on the consumer-side with 0 emissions, the production of electric cars is certainly not a 0 emission venture. The government needs to accurately calculate the real cost to society before it decides to subsidise. If the government fails to accurately calculate this, then there is a bigger chance of government failure and the policy not improving welfare. It may be better for the government to specifically target firms that do not produce negative externalities at all, as there is less potential risk for a government failure.
The next point relates to a moral hazard problem faced by some firms receiving subsidies. Governments providing subsidies to firms may discourage the firm from trying to be competitive and reduce their costs further. Without the subsidy, the firm may have attempted to reduce their costs to a more productively efficient level where they maximise their output with respect to minimising their costs. With the government’s help, there is a disincentive to do so. It would depend on the size of the subsidy given and the length of time it is given for - with bigger subsidies for prolonged periods the firm has more incentive to become lazy. If the government did not subsidise at all, the firm is more likely to work harder to boost productivity and innovate further to stay in business, especially if there is plenty of competition from other firms.
Another point refers to the opportunity cost of the subsidy. Take a look at the diagram above. You will see the size of the subsidy equal to the area of the two shaded boxes. If the size of the subsidy is very large, there is a greater risk of government failure - especially if the government already has a large government debt to pay. This subsidised money could have been used to better other industries that would also benefit society. An example would be defibrillators which is a machine used in the healthcare industry. The government does not routinely subsidise these and the welfare benefit of these is very easy to see because it saves people’s lives. The government could also subsidise the education sector instead of the car/energy industries. Again, the risk would depend on the size of the subsidy and the length of time it is paid to the firm for. The government would also have to have a high level of confidence that the policy will work and the benefits to society have been accurately forecasted beforehand.
There are some benefits to subsidising these industries. If the government were not to subsidise the car and energy industry then it could lead to a lack of innovation which society does have a need for. Electric cars and new forms of clean energy production are required for us to sustainably continue producing goods and services. This is important because it is not optimal for society’s welfare to diminish over the generations - instead welfare should increase over time. Some would say that subsidisation into these key industries will help with the research and development that is needed to improve long-term welfare. In the short-term without subsidisation, the development of clean energy and transport may fail due to firms being interested in profits.
Another benefit of subsidising these firms is the employment benefits that could potentially be brought to the country. For example, Nissan has a production plant in Sunderland which could not have existed had it not been for the government subsidies. This could lead to hundreds or thousands unemployed in that region and possibly even more in related industries. The government must carefully calculate the potential benefits this employment brings to the country.
Overall, subsidies can bring about positives and negatives to society. But there are a lot of factors that need to be taken into account. The size of the subsidy needs to be carefully calculated according to what is the socially optimal level of production. The government also needs to take into account how long the subsidy is granted to the firms for. Too long, and the firms may become dependent on the subsidies which could give birth to inefficiencies in production. Too short, and the firm may not respond in a strong enough way to benefit society. In either of those cases, the government would have failed. The government also needs to assess the opportunity cost of the policy, and be sure that there exists no other area where subsidies could bring about a higher net social benefit. The government also needs to take into account the elasticity of demand. If demand is inelastic in the market, then subsidies would bring about little benefit and greater subsidisation would be necessary, further increasing costs. Another thing is the potential of the firm not to pass on the savings to the consumer in the form of lower prices. The firm could choose to simply absorb the subsidy and increase profits. There has to be a competitive marketplace for the firm to be encouraged to price compete and hence boost quantity demand/supplied.
In conclusion, governments need to be very careful when subsidising any industry, nevermind cars and energy firms. In the car and energy case, there would have to be an accurate cost-benefit analysis of the subsidy in order to calculate the potential benefits to society. Car and energy firms already make huge levels of profits: billions of pounds annually would not be an understatement. So some would feel that there are other industries that need the subsidy more than these firms. But because car and energy firms are also key to the development of sustainable energy and transport, if the subsidy yields a strong enough long-term benefit then the subsidy should be granted, if probability of success is very high.
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