Subsidies for Postive Externalities
Subsidies involves the government paying part of the cost to the firm. This reduces the price of the good and should encourage more consumption.
A subsidy shift the supply curve to the right.
What is Justification for Subsidising goods with positive externalities?
In a free market, people ignore the positive externalities of consumption, e.g. when cycling to work, you don't consider the reduction in pollution your decision creates.
In a free market, there is under consumption of good with positive externalities.
The free market equilibrium is at Q1. But, social efficiency occurs at Q2 (where SMB = SMC)
To increase consumption and production, the government can offer a subsidy to reduce the price and increase quantity.
Diagram of Subsidy on Positive Externality
- Subsidy = P0 -P2
- The supply curve shifts to S2 and Price falls from P1 to P2
- People will now consume more at Q1
- Q1 = Social Efficiency: because SMC = SMB
Advantages of Subsidies
- Enables greater social efficiency. Consumers end up paying the socially efficient price which includes the external benefit.
- If you subsidise public transport, it will encourage people to drive less, and reduce their negative externalities.
Disadvantages of Subsidies
- Is expensive and will requires higher taxes.
- Difficult to estimate the extent of the positive externality
- Giving subsidies to firms may encourage inefficiency, because the firms can rely on government aid.
- Govt Failure: The govt may have poor information about the service and how much to subsidise.
Essays and Revision Notes on Market Failure
- Market Failure
- Negative Externalities
- Positive Externalities
- Public Goods
- Merit and Demerit Goods
- Policies to Overcome Market Failure
- Tax on Negative Externality Diagram
- Subsidy on Positive Externality Diagram
- Cost Benefit Analysis
Essays and Revision Notes on Government Failure
- Government Failure
- Privatisation of Public Services
- Should We Pay for NHS?
- Rationing and the NHS
- Why Government Intervention ?
- Market Failure
- Buffer Stocks
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