Discuss The Extent To Which Subsidies Are The Best Way To Correct Market Failure.

Discuss the extent to which subsidies are the best way to correct market failure (20)

A subsidy is a payment made by the government, usually to a firm, to encourage a specific course of action. Market failure occurs when the market fails to provide full efficiency.

Sometimes a subsidy can be effective in correcting market failure. For example, if the market failure is due to positive externalities (where social marginal cost is higher than private marginal cost) then the subsidy might work. This is because in this case the negative externalities are ignored when price is set, so the goods are under-consumed. A subsidy would lower the cost of production, increase the quantity supplied and demanded, and so eliminate the market failure. This can be seen on a diagram:

DIAGRAM: SUPPLY SHIFTS RIGHT, WITH EXPLANATION

The extent to which the subsidy is effective depends on the price elasticity of demand. If it is highly inelastic, then the subsidy would increase production and consumption by less than if it was highly price elastic. Knowing PED values in advance would help, but even then they may change over time, making this issue quite important

DIAGRAM: COMPARATIVE ELASTITICITES, WITH EXPLANATION

It can also be very difficult to accurately measure the size of the externality, so the rate of subsidy selected might be incorrect. This seems a significant issue sometimes there might actually be no positive externality at all, so the subsidy might cause a market failure.

As the value of elasticity changes over time, this means that the subsidy might become more or less effective over time which could be a problem. Then again, it could be fine-tuned, which could reduce this problem. Even then, there might be a cost involved in doing the fine tuning, which would increase the risk of government failure.

Not all consumers would be affected equally by the subsidy& those on low incomes would be expected to benefit most, as the reduction in price due to the subsidy would be a larger part of their disposable income. This would be especially important for necessity goods (like some foods), and less important for goods which are non-essential (like most air travel).

One potentially major problem with a subsidy is the cost& this brings an opportunity cost to the government as money spent subsidising one market cannot also be spent on another. The extent of this problem depends on the cost of the subsidy as a percentage of total government spending the larger it is, the more serious the problem would be.

It is also true that a subsidy would not correct all forms of market failure. & Whilst it might correct those caused by positive externalities, and even merit goods, it would be irrelevant if the market failure was due to negative externalities or the existence of demerit goods. This is because in both cases the good would already be over-consumed& a tax of some sort would seem more appropriate to correct the market failure in these cases.

Also, where the market failure is caused by the existence of merit goods, an information campaign might have a better effect than a subsidy:

DIAGRAM, MERIT GOOD, EXPLANATION

Here the information campaign might alert the consumers to the full private benefit of the good, and the might increase consumption accordingly. If the cost of the information campaign was lower than that of the subsidy, then this might be a more efficient solution. However the costs of the information campaign are certain but the benefits are perhaps less certain a subsidy might have a more predictable effect.

Finally, a law forcing people to consume merit goods, or goods with positive externalities could be used to correct the problem of under consumption. To some extent the Education Act is an example of this, as it forces people to attend school until the age of sixteen. However the costs of enforcing such legislation could be very high indeed, and in some cases it might be impossible to enforce at all& for example it would be impossible to force people to eat and apple a day as it would be impossible to monitor their apple consumption. On the other hand, where the good is produced by just a small number of firms, then then a subsidy could be quite easily employed.

On balance, the evidence suggests that a subsidy can be an effective way to correct some forms of market failure (but by no means all of them), but that the problems and costs of implementing the subsidy might be so large as to make the intervention inefficient. The biggest weaknesses of subsidies is that they only correct market failure caused by under-consumption, and that they can bring a very high opportunity cost. The evidence is certainly not strong enough to conclude that subsidies are always the best cure for market failure.