Subsidies for Positive Externalities

Subsidies involves the government paying part of the cost to the firm to encourage more consumption, therefore supply shifts to the right.

Diagram of Subsidy on Positive Externality

• Subsidy = P2- P0
• The supply curve shifts to S2 and Price falls to P2
• People will now consume more at Q2
• Q1 = Social Efficiency: because SMC = SMB

Advantages of Subsidies

• a.) Increases social efficiency
  b.) Provides goods/services at a cheaper price

Disadvantages of Subsidies

• Is expensive and will require higher taxes.
• Difficult to estimate positive externality
• Giving subsidies to firms may encourage inefficiency, because the firms will rely on government aid.
• Govt Failure: The govt may have poor information about the service

Tax 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 anincrease 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.

2nd Term Holiday Homework

1. Discuss whether the introduction of trade barriers against imports can always be justified. [12]

2. Discuss whether the formation of regional trading groups, such as ASEAN and NAFTA, is desirable. [12]

Tariffs

A tariff is, quite simply, a tax levied by the government on imported goods. This forces the price of the good up and so makes it relatively expensive in the home market. This benefits the domestic industry as its product now appears relatively cheaper to home consumers. The home industry has, in effect, been 'protected' from the foreign competition.

It should be noted that the foreign firm could absorb the tax by reducing its price until the overall price (including the tariff) is the same as it was before the imposition on the tax. The firm is unlikely to be able to do this forever, though, and the tariff imposing country could always raise the tax again.

The diagram below shows the effect of introducing a tariff on a good in a previously unprotected market. This diagram is very popular with examiners for multiple-choice questions. It is important that you understand fully what is going on in this diagram.

The world supply curve is assumed to be horizontal (S_W). The domestic supply curve above point G no longer exists given that the world price (P_W) now dominates. The effective supply curve, therefore, is the line JGS_W. The demand at price P_W is OQ₄, of which OQ₁ is supplied domestically. This means that the rest is imported (Q4 − Q1). Notice that consumer surplus is represented by the large triangle ACP_W and that producer surplus is represented by the much smaller triangle GJP_W.

If the government now decides to protect the home industry be imposing a tariff on world imports, the world supply curve will shift up to S_W+T and the new price will be P_W+T. At this higher price, demand falls back to OQ₃, of which OQ₂ is supplied domestically (more than before). Imports, therefore, have now been reduced to Q₃ − Q₂.

The higher price has reduced consumer surplus from ACP_W to ABP_W+T. Some of this welfare loss has been transferred to other parties. The black shaded trapezium (P_WP_W+THG) is now extra producer surplus (or profit for the domestic producers). The green rectangle (BEFH) is now government revenue from the tax on imports (number of imports times the tax per unit). The two red triangles represent losses to society.

The first red triangle (FGH) represents the loss due to the fact the quantity between Q₁ and Q₂ used to be imported at a total cost in terms of resources used of FGQ₁Q₂ (number of units supplied times cost per unit), but is now produced domestically at a higher cost (HGQ₁Q₂). The upward sloping domestic supply curve shows that the cost per unit is rising for the domestic firms, whereas this cost per unit is constant for foreign producers.

The second red triangle (BCE) is simply the loss of consumer surplus due to the fact that consumers used to be able to buy the quantity between Q₃ and Q₄ at price PW and now they don't, because at the higher price the demand is only Q₃.