Evaluate using appropriate diagrams the effectiveness of a subsidy to deal with the case of positive externalities of consumption. MPC=MSC Deadweight welfare loss PSO 1 PME 1 1 1 1 1 1 QME QS O MP B MSB Market equilibrium is at QME where MPB=MPC.However the economy performs best at the social optimum of QSO where MSC=MSB. Therefore as market equilibrium is lower than the social optimum this leads to a deadweight welfare loss where social marginal cost is significantly larger than social marginal benefit.Society would benefit by increasing the output to QSO and to achieve this the government can offer a subsidy increasing quantity produced and lower price levels to increase consumption and production. The purpose of a subsidy is to increase the consumption of merit goods that are usually under consumed relative to the social optimum. The subsidy helps with the production of the product and so quantity and quality produced increases hence the shift of MPC when a subsidy is implemented following the eradication of the deadweight welfare loss. The firm's cost of production decreases and so they are more willing and able to sell products at a lower price whilst still maintaining profit margins. This is shown in the graph when MPC shifts to the left and the price level decreases from P1-P2,whilst consuming at the social optimum quantity Re to the the subsidy of Po-P2. This incentivises more consumption as more consumers are able to purchase due to lower prices. P1 Also, reducing underconsumption for a particular merit good could also decrease the negative externalities of a demerit good that acts as a substitute.For example if the government were to provide a subsidy towards the production of public transport, the price MSB QSO Q1
level for public transport decreases and thus individuals are more likely to consume it. This may result in a decrease of people driving cars and decrease the negative externalities that come with consumption such as pollution or congestion. However, there are problems with granting a subsidy.One main reason being the possibility of over/under-estimating the positive externalities which leads to granting too big of a subsidy or too little of a subsidy. MPC=MSC PSO P1- P2 - 1 1 1 1 1 1 1 1 1 1 1 1 1 + 1 1 1 1 1 1 Q1 QSO Q2 MSB MPB MPC +Large subsidy In the graph above it shows what happens when a subsidy is too large.In this case the new equilibrium quantity supplied is at Q2 which is significantly larger than the social optimum quantity therefore this would lead to overconsumption.Overconsumption is a negative thing as large amount consumed people do not really benefit from consumption, for example education may be overconsumed which leads to individuals not really caring about education and thus leading to added cost.Another example is when consumers overconsume healthcare and use it when not needed for example a headache, this provides the NHS with more work for insignificant causes. This occurs when the government overestimate