What this lesson teaches
I can explain, draw and evaluate the ways a government corrects market failure, from price controls and taxes to regulation and direct provision.
Syllabus K343, 2.10.3. Government intervention to address market failure: definitions, drawing and interpretation of diagrams, advantages and disadvantages of: maximum and minimum prices in product markets, indirect taxation, subsidies; definitions, advantages and disadvantages of: regulation, privatisation, nationalisation, direct provision of goods and services, quotas, e.g. for the extraction of natural resources
Make a guess
The government subsidises flu vaccines, but many people skip them because they fear needles. Will the subsidy raise vaccinations a lot?
- Not much, because price is not their main barrier.
- No. A subsidy changes behaviour for goods, not for health care.
- Yes. A cheaper vaccine brings a large rise in take-up.
Show the answer
Not much, because price is not their main barrier.
A subsidy lowers the price. If fear stops people, demand is price inelastic for them, so take-up rises only a little.
A subsidy lowers firms' costs, so supply rises, price falls and more of the good is consumed.
A subsidy is a payment from the government to producers to lower their costs. Supply increases. On a diagram, supply shifts down by the amount of the subsidy per unit.
Price falls and quantity rises. Governments subsidise merit goods and goods with external benefits, such as public transport, vaccines or solar panels, so that more people use them.
Advantages: the good becomes cheaper and more widely used, so society gains more of the external benefits. Poorer households can afford it more easily.
Disadvantages: the subsidy is paid from taxes, so it has an opportunity cost. Firms may rely on it and become less efficient. If demand is inelastic, consumption rises only a little, and some of the money simply raises firms' profits.
- Subsidy
- Government payment to producers; supply shifts down.
- Effect
- Price falls, quantity rises.
- Opportunity cost
- The tax money could have been used elsewhere.
Worked example: Should a government subsidise vaccines?
Suppose a government pays clinics $20 for every flu vaccine they give.
- Supply shifts right, so the price patients pay falls and more people get vaccinated.
- External benefit: fewer people catch flu, so fewer sick days and less pressure on hospitals.
- Cost: the subsidy is paid from tax revenue, which could have funded something else.
- Depends on: whether price is what stops people getting vaccinated, or fear and lack of information.
Watch out for this
A subsidy is a payment to consumers, so it shifts demand.
In this syllabus a subsidy is paid to producers. It lowers their costs and shifts supply, not demand.
Check your understanding
A government gives producers a subsidy on solar panels. What happens in the market?
- Supply decreases and the price rises, as firms rely on the subsidy.
- Demand decreases, because buyers distrust a good the government supports.
- Supply increases, so price falls and quantity sold rises.
Show the answer
Supply increases, so price falls and quantity sold rises.
Right. Lower costs let firms supply more at every price.
Check your understanding
A government pays producers a subsidy of $0.50 for each unit. After the subsidy, 40,000 units are sold. What does the subsidy cost the government?
- $80,000
- $20,000
- $200
- $40,000
Show the answer
$20,000
Right. Cost = subsidy per unit x quantity sold after the subsidy = $0.50 x 40,000.