Chapter 3: subsidies

What is a subsidy?

A direct payment usually from a government to encourage production or consumption. Usually to increase production of merit goods that generate positive externalities.

What is the significance of decreasing prices due subsidies [2].

Encourage production at the socially optimum level of output. Consumers end up paying the socially efficient price which includes the positive externality. However, there is a danger that government subsidies may encourage firms to be inefficient and they come to rely on subsidy rather than improve efficiency and produce at the socially optimum level of output. This is know as producer capture. Over subsiding can occur.

What is the significance of subsidising public transport?

If you subsidise public transport, it will encourage people to drive less, and reduced their negative externalities. In the long term, subsidies for a good will, help change preferences. It will encourage firms to develop more products and positive externalities. However, if producers do not increase supply to the socially optimum level of output, and focus on increasing profit, it will end up costing the tax payer. There is an opportunity cost of money spent on subsiding that could have been better spent elsewhere.

What is the significance of decreasing prices due subsidies?

Incentive for producers to increase supply. Lower costs for producers, potentially lowering prices to consumers. (Extension in demand). However, difficult to estimate the extent of the positive externality, therefore the government may have poor information about the service and how much to subsidise. May lead to overproduction.

What is the significance of raising revenue to give subsidies to reduce market failure?

The most efficient way to raise revenue for subsidising positive externality would be to tax goods with negative externality e.g. Tax cars driving in city centre (congestion charge) and use the money to subsidise public transport. However, opportunity cost occurs, the cost of expensive subsidies will have revenue generated through for example taxation. Some taxation e.g. Income tax, may reduce incentives to work and can increase negative externalise such as crime.