Use of subsidies to correct market failure from a positive consumption externality

Question 1

Analysis of market failure from a positive consumption externality

Answer 1

• Consumers only consider private benefits when deciding how much to consume of a merit good (education/vaccines) - examples of private benefits
• Market equilibrium level of output at Qm
• Each unit consumed beyond Qm would lead to net welfare benefit to society since MPBs greater than MSCs
• Socially optimal level of consumption occurs at Qopt
• Net welfare loss triangle

Question 2

Benefits of a subsidy

Answer 2

• Lower the costs of production for producers
• Pass on cost savings in form of lower prices
• People begin the consumer more of the good
• Shifts the MPB curve outwards
• Perfect level of subsidy is vertical distance between MPB and MSB curve - MPB should shift to meet the MSB
• Incentive for the firm to become more socially desirable - gov rewards firms who produce socially efficient goods

Question 3

Disadvantages of a subsidy in this context

Answer 3

• Dependent on price elasticity of demand
• Subsidies may be ineffective if the PED is inelastic - low price may not be enough to ensure a significant increase in consumption
• Difficult to calculate the size of the externality and it is funded through tax payers money - opportunity cost - priorities of government - long-term benefits
• Moral hazard problem if firms become overly reliant on the subsidies and produce inefficiently - create barriers to entry - new, more efficient firms cannot compete with the artificially low prices
• Firms may abdorb the subsidy - presence of competition should prevent this

Question 4

Judgement

Answer 4

• Perhaps other methods could be used alongside subsidies
• Information provision can highlight the benefits of consumption so consumers themselves can choose to increase consumption provided they behave rationally - less costly than subsidies
• Regulation could be used but generally unpopular