Government intervention - subsidies, polluter pays policies

Notes

Government intervention - subsidies, polluter pays policies

‘Polluters pay’ policies

Demerit goods often cause negative externalities, such as pollution. 

Other 'polluters pay' policies include:

  • Tradable permits

    A firm is allowed to produce a certain level of pollution. 

    If it produces more it will have to pay for additional permits. 

    If it produces less, it can sell its unused permits for a profit to other companies.

  • Charges for dumping waste products, 

    eg landfill tax

  • Fines for breaching regulations

Subsidy

A subsidy is a financial contribution from government to reduce the costs of production. 

It can have a number of aims:

  • To reduce cost of living by making essential goods affordable.

  • To encourage production or consumption of merit goods.

  • To stabilise incomes of producers (eg farm subsidies).

Impact of a subsidy

A per-unit subsidy shifts the supply schedule downwards (rightwards) by the amount of the subsidy per unit.

Illustration

B3b Government intervention - subsidies, polluter pays policies

The equilibrium is initially at A, where the price is $10 and the quantity is QO.

The government grants a subsidy of $5 per item.

This encourages producers to make more of the product, so the supply curve shifts to S1 and the amount supplied increases to QS.

There is now excess supply of QS - QO.

So suppliers reduce their price until a new equilibrium is reached at B.

At B the price is $8, so consumers benefit from $2 of the subsidy ($10 — $8) and suppliers take the rest of the benefit ($3).

Price elasticity and the impact of subsidies

The impact of a subsidy will be that the price of the good falls, and that the quantity produced and sold rises 

(ie from QO to QE in Illustration above). 

The extent to which a price fall causes a rise in quantity depends on the price elasticity of demand and supply.

  • If the price elasticity of demand is very law then the quantity demanded will not rise significantly as a result of the lower price.

  • If the price elasticity of supply is very low then the quantity supplied will not rise significantly, because supply may be fixed in the short term regardless of price eg subsidies for nuclear fuel.

Notes