In this video we’ll apply our knowledge of subsidies to overcome market failure.
Specifically we’ll see how subsidies can be applied to overcome the market failure
associated with positive consumption externalities and positive production externalities.
First we’ll look at positive consumption externalities, specifically those associated
with vaccines.
Vaccines are used to improve immunity against particular diseases.
If I vaccinate my son against diseases such as measles, mumps and rubella – then he
won’t suffer from them.
If he doesn’t suffer from these diseases, then he cannot spread it to anyone else.
Getting him the vaccine has greater social benefits, however I am not concerned about
those when I take him to the doctor.
My primary concern is his health and preventing disease for him.
I am willing to pay for the benefits my son receives but not the rest of society.
If this is the prevalent mindset for most individuals, vaccines are likely to be underconsumed.
Therefore the government may intervene and offer a subsidy for getting vaccinations.
We’ll see what this looks like next.
Since this is a subsidy to encourage the consumption of vaccines, we are going to focus on the
private benefit and social benefit.
The free market equilibrium occurs where marginal private benefit is equal to marginal private
cost.
At price Pe, quantity Qe is consumed.
This is problematic as an external benefit exists.
MEB represents the marginal external benefit per unit.
Thus, the marginal social benefit curve is above the marginal private benefit curve.
Our socially optimal level of consumption is quantity Qo at price Po.
We need to achieve two things, one getting producers to produce quantity Qo and also
getting consumers to buy it at that price.
How can we achieve that?
This situation indicates that there is a potential welfare gain of triangle ABC if the government
can resolve this market failure.
We’ll see how that’s done with a subsidy next.
This is our free market consumption of vaccines in equilibrium.
The government wants consumers to consume more of the good and will increase demand
by providing consumers with a subsidy equal to the marginal external benefit.
This will increase demand from D to D1 and result in a higher market price Ps and higher
quantity consumed of Q1.
Therefore producers will be willing to supply Q1 vaccines and consumers will buy it.
Producers receive a price of Ps, consumers pay Pc out of pocket and receive a subsidy
of Ps-Pc to purchase the vaccine.
The government is thus able to increase the consumption of vaccines and overcome the market
failure.
Next up are positive production externalities.
Here we’ll consider the case of government funding to support the development of airports.
The development of infrastructure brings benefits to the economy, and airports particularly
will benefit local businesses.
Nearby hotels, restaurants and tourist sites will see an increase in visitors due to the
increased accessibility of the location.
These benefits to the local economy and beyond are why the government has an interest in
subsidizing the development of airports.
For example, at New York’s LaGuardia airport, Delta Airlines is contributing $3.4 billion
out of the $4 billion needed to build a new terminal at the airport.
The remaining $600 million is coming from the Port Authority of New Jersey and New York.
The Port Authority is a government agency that is providing funding alongside the private
airline company Delta Airlines.
The Port Authority is subsidizing the development of the airport because of the external benefits
it will bring.
How does that look on a diagram?
We’ll see that next.
CREDIT VIDEVO video author
We start with the marginal private benefit and marginal private cost curves.
The marginal social benefit and marginal private benefit curves are the same.
In free market equilibrium, the price is Pe and quantity produced is Qe.
We’d like to increase the quantity produced because of the external benefits from production.
The marginal social cost is lower than the marginal private cost because it includes
external benefits.
The socially optimal level of production is Qo at a price of Po.
There is a potential welfare gain of triangle ABC.
How will a production subsidy help address this market failure?
Let’s see.
The initial equilibrium for this market is P*Q* A subsidy equal to the marginal external
benefit is given to producers resulting in an increase in supply.
The price paid by consumers is now P1 at a quantity of Q1.
Go back to the example of the airport.
If the airport was paid for entirely by private firms, they would charge higher fees for access
to the airport.
By subsidizing the construction of the new terminal, the government is able to reduce
some of those costs so that more passengers can enjoy affordable access.
By now you should have a better understanding of the application of subsidies to correct
market failure.
It’s important to distinguish between subsidies for production and consumption.
If you have any questions, leave them below or email me at enhancetuition@gmail.com.