Subsidies Flashcards
Subsidies
A direct payment or Grant given by the government to producers of goods and services
What is the purpose of a subsidy?
To increase production and reduce costs of production making it more profitable to supply
What happens once a subsidy is given?
The supply curve shifts to the right as firms costs of production decreases and so it is more profitable to supply
- there is an extension on the demand curve as goods and now more affordable for consumers
Application of a subsidy to market failure
As a subsidy is given, firms cost of production decreases and so the MPC Curve shifts to the right as it is more profitable
- we assume the government has perfect information and will set the subsidy the exact size of the positive externality in order to shift Qm back to Qstar
- get rid of allocative inefficiency as firms were previously allocating too few resources to the production of something that does benefit society
- This internalises the externality
Problems with granting a subsidy
1. Produces may not react to the subsidy
- firms may retain the subsidy as profit when confidence is low and uncertainty is high
- won’t invest especially during a recession this means that it will not improve underproduction or under consumption
2. Opportunity cost
- if there is a subsidy, less money is spent on other goods and services so there is an opportunity cost for the government
- bad as the government has a scarce and limited budget
3. Depends on the ped of the good
- quantity demanded changes less than proportionally to the change in price so it is not effective if it is an inelastic good
- quantity demanded change is more than proportionally to the change in price so it is effective if it is a elastic good
4. Difficult to know how much of a subsidy to grant
- if the subsidy granted is too small there is still going to be under consumption or underproduction
- if the subsidy is too big firms may start to produce a lot more so could lead to over production
