Subsidies
How governments intervene
One of the ways governments can intervene to correct a market failure is by introducing a subsidy in the free market.
Why would a government want to subsidise a good/service?
A government is most likely going to subsidise a good or service because it causes a market failure in that there is not enough of the good/service being bought or sold.
Take, for example, the market for electric cars - If there were no government involved then electric cars would cost too much and may not break out into the market. People would probably stick to buying petrol/diesel cars until electric cars were priced more competitively. However, we know that electric cars should be better for the environment than cars that run on petrol/diesel. The market for electric cars could fail because of the positive externality problem. They could even be classed as merit goods as they are good for society and there are not enough of them in production.
The government acts in the interest of wider society and subsidises electric cars so that consumption is increased. This improves the welfare of society as a whole as more and more electric cars are sold.
What makes a subsidisation a good method of intervention?
Subsidies can be good for a number of reasons. Some of these reasons are because:
Subsidies can lower the market price - in the majority cases, the producer will pass on some of the savings onto the consumer, thus decreasing the price. This is because the producer wants their sales to go up and their costs are effectively lower with the subsidy. They are able to produce more at a lower price level than before. This solves the problem of underconsumption/underproduction. Lower prices should lead to a higher allocation of resources
Incentivises firms to become more socially desirable - if the government rewards firms who produce socially efficient goods then firms are more likely to do the right thing and make them.
What are the disadvantages of subsidies?
Depends on the price elasticity of demand - subsidies will be less effective if PED is inelastic. This is because people are less concerned about the price they pay and the lower price may not be enough to ensure a significant enough increase in consumption/production.
Accuracy in calculating the size of the externality - some externalities are very difficult to measure. What is the true benefit of education? Don't different people value the education differently? How much does it cost the government to work out the benefits of a education? If calculating the externality is not accurate and is very costly, then the chance of government failure is high.
Cost to the government/taxpayer - the money for subsidies comes from the government, which in turn comes from the taxpayer. Taxes may even have to rise to pay for the subsidies given. Therefore, the government must ensure that the benefit to society by subsidising the good/service must be high.
Changes in firm behaviour - the government could be subsidising a firm, thinking that the firm will continue to be competitive and run efficiently. But with subsidisation comes the risk that the firm will change its behaviour and become lazier, as there is less need to run efficiently. This is akin to the moral hazard problem.
The firm may not pass on the benefits - the firm may choose to absorb the subsidy for itself, or at least the majority of it. If the firms acts in this way, then there is little benefit to the consumer and little more will be consumed. The desired effect on society will not be achieved. However, this is less likely to happen if the marketplace is competitive. With strong competition from other firms, the firms is likely to offer a low and competitive price.
What have we learned?
Why the government uses subsidies
Advantage and disadvantages of subsidies
Subsidy diagram
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