Subsidies for Positive 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 shifts 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 because people usually ignore the ‘external benefits’ their decisions make.

Examples of goods with positive externalities in societies

• Health care – free universal health care can ensure everyone gets vaccinated; this prevents the spread of infectious disease, which benefits everyone. In other words, you have a personal benefit from other people being healthy.
• Collecting refuse and litter – If litter is picked up it benefits everyone else who can enjoy a more beautiful environment. It also helps improve public health.
• Education. If the long-term structurally unemployed workers gain useful training and education, it enables them to find work. This has benefits for other people in society -  The government receives more tax revenue and pays less unemployment benefit. There is also a less tangible benefit of a more cohesive society.

Diagram showing market failure when there is a positive externality

The free market equilibrium is at Q1. because S=D. People maximise their welfare where private marginal benefit = private marginal cost.

But, social efficiency occurs at Q2 (where SMB = SMC), therefore, at the free market equilibrium, the social marginal benefit is greater than the social marginal cost. Society would benefit from increasing output until Q2.

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, the quantity increases from Q1 to Q2.
• Q2 = 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. In the long term, subsidies for a good will help change preferences. It will encourage firms to develop more products with positive externalities.

Potential problems of subsidies

• The cost will have to be met through taxation. Some taxation, e.g. income tax, may reduce incentives to work. Though the most efficient way to raise revenue for subsidising positive externalities, would be to tax goods with negative externalities, e.g. tax cars driving in city centres (congestion charge) and use the money to pay for public transport.
• Difficult to estimate the extent of the positive externality, therefore the government may have poor information about the service and how much to subsidise.
• There is a danger that government subsidies may encourage firms to be inefficient and they come to rely on subsidy rather than improve efficiency.

Taxes on Negative Externalities

1. Taxes On Negative Externalities

 

DISADVANTAGES of taxes

• Difficult to measure the level of negative externality e.g. what is the cost of pollution from a car?
• If Demand is inelastic then higher taxes will not reduce demand much
• Taxes will cause inequality
• Cost of administration
• Possibility of evasion. E.g. with tax on disposing of rubbish there has been an increase in fly tipping (illegal Dumping of rubbish)
• May be difficult to decide who is causing pollution

Advantages of Taxes

• Provides incentives to reduce the negative externality such as pollution. E.g. cars have become more fuel efficient
• Social efficiency, 1st best solution (where MSC = MSB)
• Taxes raise revenue for the govt. This can be spent on alternatives.

Positive Externalities

Negative Externalities

Division of Labour & Specialisation

Specialisation occurs when workers are assigned specific tasks within a production process. Workers will require less training to be an efficient worker. Therefore this will lead to an increase in labour productivity and firms will be able to benefit from economies of scale (lower average costs with increased output) and increased efficiency.

Example of Specialisation and Division of Labour

In the process of producing cars, there will be a high degree of labour specialisation.

• Some workers will design the cars
• Some will work on testing cars
• Some will work on marketing
• Some workers will work on different sections of the assembly line. Their job may be highly specific such as putting on tyres e.t.c.

Specialisation within economies

Specialisation can also mean that individual countries can produce certain goods that they are best at producing and then exchange them with other countries.

The theory of comparative advantage states countries should specialise in producing those goods where they have a lower opportunity cost (relatively best at producing)

Specialisation requires trade. Specialisation and trade means that countries that produce no oil can consume oil products and countries with large reserves of raw materials can export them in exchange for other goods that they need. This helps reduce the problem of scarcity in individual countries and enables countries PPF to shift outwards.

If there is increased trade there will also be increased competition. This means that domestic monopolies will now face competition from abroad therefore they have increased incentives to cut prices and be efficient.

Problems of Specialisation

However there are problems of specialisation. Firstly if workers do specific tasks it may become boring and their productivity may fall as a result.

Secondly poor countries may be encouraged to use up their non-renewable resources to sell to developing countries, therefore in the long term we could run out of non-renewable resources

Over specialisation in one country can lead to countries becoming over dependent on one particular commodity, e.g. if a developing country specialises in the production of a primary product their income may be adversely effected by bad weather conditions.

Critics of free trade argue that with increased specialisation there will be intense competition to cut costs and therefore wages will have to fall. However this point is not necessarily true because firms can compete by producing capital-intensive goods with better technology.

Functions of Price

Rationing, signalling and incentives

The interaction of buyers and sellers in free markets enables goods, services, and resources to be allocated prices. Relative prices, and changes in price, reflect the forces of demand and supply and help solve the economic problem. Resources move towards where they are in the shortest supply, relative to demand, and away from where they are least demanded.

The rationing function of the price mechanism

Whenever resources are particularly scarce, demand exceeds supply and prices are driven up.  The effect of this is to discourage demand and conserve resources. The greater the scarcity, the higher the price and the more the resource is conserved. This can be seen in the market for oil. As oil slowly runs out, its price will rise, and this discourages demand and leads to more oil being conserved than at lower prices.

The signalling function of the price mechanism

Price changes send contrasting messages to consumers and producers. Rising prices give a signal to consumers to reduce demand or withdraw from a market completely, and they give a signal to producers that they should increase production or enter the market. Conversely, falling prices give a positive message to consumers, to consume more, but a negative message to producers, the produce less. For example, a fall in the price of PCs relative to laptop computers sends a message to producers to manufacture more laptops.

The incentive function of the price mechanism

An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to producers to supply more, or to enter the market, because they provide the possibility or more revenue and increased profits. For example, a rise in the wage rate, which is the price of labour, provides an incentive for the unemployed to join the labour market.

Consumer & Producer Surplus

Tax Burden