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Title: Evaluate the extent to which subsidies can correct the market failure associated with underconsumption
Description: Evaluate the extent to which a subsidy given to producers might encourage an increase in the consumption of a product such as pu’er tea which generates positive externalities. [25]
Description: Evaluate the extent to which a subsidy given to producers might encourage an increase in the consumption of a product such as pu’er tea which generates positive externalities. [25]
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Evaluate the extent to which a subsidy given to producers might encourage an
increase in the consumption of a product such as pu’er tea which generates positive
externalities
...
A market failure could be the under consumption of a good
with positive externalities
...
This market failure can be fixed through a subsidy, which is a grant given by the
government to producers to encourage the production of a good or service
...
This
would benefit healthcare systems as there may have a reduced number of cases of heart
disease, therefore reducing the strain on the health service
...
The current free market equilibrium is P,Q, this is where
the marginal private benefit (D=MPB) meets the marginal social cost (S=MPC=MSC)
...
At the free market equilibrium (P,Q) there is too low
consumption at a too high price resulting in underconsumption
...
Subsidies are given to produces to
decrease their cost of production, thus increasing producer’s incentive to supply the good,
making them more willing and able to sell at a given price and time
...
This decreases the price from P to P2, a cheaper price means consumers are more
willing and able to buy at this given price and time
...
This would improve economic welfare from ABC
to BDE, and then increasing allocative efficiency
...
S=MPC=MSC
C,P,B
S+Subsidy
P1
P
P2
MSB
D=MPB
Q Q2 Q1
Q
The effectiveness of this subsidy would depend on the price elasticity of demand of the good
...
As shown in
graph 1
...
However, if the Pu’er tea is price elastic a decrease in price from P to P1 would
lead to a more than proportional increase in quantity demanded from Q to Q1
...
Therefore, when the good is price elastic the subsidy has a stronger effect on the
new equilibrium quantity, which would make it effective to correcting the market failure of
under consumption as there is a more than proportional increase in quantity demanded,
which would move the free market equilibrium closer to the social optimum
...
This is because the exact value of the
marginal external cost and the marginal external benefit must be calculated
...
If a subsidy is too small the effects would
not be significant enough to correct the market failure as shown on the graph below
...
This would lead to a small shift of S=MPC=MSC curve to the right creating the
S+Subsidy curve, decreasing price from P to P2
...
This would not be effective at correcting the market failure of
under consumption as the social optimum is still far greater than the free market
...
Opportunity cost is the loss of other alternatives when one alternative is chosen
...
S=MPC=MSC
S+Subsidy
C,P,B
P1
P
P2
MSB
D=MPB
Q
Q1
Q
This type of subsidy may not be effective if the producers become too reliant on it, by using
the subsidy to add to the firm’s profit rather than to lower prices in order to correct a market
failure
...
Meaning that
the government would have to continue implementing the subsidy at the same level creating
an opportunity cost
...
However, the market failure would occur again if the subsidy was reduced
and the product may become under consumed again
...
Alternative – maximum pricing
...
However, it may not be the price of
the product that is causing it to be under consumed, there may just be a lack of demand for
this particular product, due to substitutes
...
Title: Evaluate the extent to which subsidies can correct the market failure associated with underconsumption
Description: Evaluate the extent to which a subsidy given to producers might encourage an increase in the consumption of a product such as pu’er tea which generates positive externalities. [25]
Description: Evaluate the extent to which a subsidy given to producers might encourage an increase in the consumption of a product such as pu’er tea which generates positive externalities. [25]