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20 mark essay on the effectiveness of subsidies
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An 18/20 mark essay showing the effectiveness of a subsidy on solving the market failure on education.
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Discuss the effectiveness of subsidies as a solution to market failure arising from positive externalities ofconsumption of education (20)
Market failure is when the free-market mechanism doesn’t allocate resources
efficiently. There are positive externalities of education, causing market failure
as consumers ignore the benefits of third parties that weren’t involved in the
transaction such as an increase in productivity in firms and a lower cost of
policing due to less crime from low unemployment. This causes a divergence
between two curves MSB and MPB due to underconsumption as quantity
consumed (Q1) is lower than social optimum (Q *). Therefore, this causes allocative inefficiency as not enough
resources are allocated, resulting in underconsumption.
(Optional paragraph) A subsidy is effective in solving market failure as social optimum is met. When the government
provides a subsidy to a firm, it lowers the firm’s cost of production, making it more profitable to supply more, which
shifts the MPC curve to the right from MPC to MPC + subsidy. This
decreases the price level from P1 to P2, therefore firms can pass on
lower prices to consumers. Since the product is cheaper, more
people can afford the good or increases the consumption of the
good. This shifts the MPB curve to the right form MPB to MSB. This
increases the quantity from Q1 to Q*. Therefore, market failure is
solved as social optimum (Q*P*) is met and welfare loss is in the
shaded region.
Therefore, social optimum may not be met as market failure is not solved so underconsumption still occurs.
A subsidy is effective as it solves market failure. When the government gives
out subsidies to a firm, it lowers the firm’s cost of production, making it more
profitable to supply more, which shifts the supply curve to the right from S 1 to
S2. This decreases the price level from P 1 to P2, therefore firms can pass on
lower prices to consumers. Since the product is cheaper, there is an extension
along the demand curve as more people can afford the good or increases the
consumption of the good. This increases the quantity from Q 1 to Q*. Therefore, market failure is solved as social
optimum is met and the new market equilibrium is at P *Q*, and the cost of the subsidy is in the shaded region.
However, the effectiveness of the subsidy depends on the elasticity of
the education. If the demand for education is inelastic, there will be a
larger effect on the new market equilibrium curve, hence a large
decrease in the price will cause quantity demanded to increase less than
proportionately, hence social optimum may not be met. However, if the
demand is elastic, then the subsidy has a stronger effect on new
equilibrium, hence quantity demanded will increase more
proportionately to the decrease in price, hence social optimum is likely to be met and market failure will be solved.
Subsidies may not be effective in reducing market failure as they can incur an opportunity cost. It is very expensive
to grant subsidies (shown from the cost of subsidy) and it incurs an opportunity
cost since governments have scarce tax revenue (on a budget constrain). This
causes a massive opportunity cost from A to B because when the quantity of
subsidies increases from S1 to S2 and other government spending reduces from
G1 to G2. Subsidies such as funding tuition fees or funding education only
benefit a small proportion of society. Therefore, the cost of subsidy (shown in
the shaded region) is not proportionate to the number of people who
benefitted. Therefore, subsidies may not reduce market failure for other goods
and services as they can incur a massive opportunity cost (when subsidising one
type of firm) due to budget constraints. Furthermore, this can cause negative
impacts in the future as governments could tax individuals to fund this. This
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