Subsidies & Price Controls
Economics: IB Diploma, topic 1.3.3
Subsidies
Governments pay producers subsidies to help keep the price of products low.
Encouraging production/consumption
- Subsidies can correct market failure by encouraging the consumption and production of a good with positive externalities.
- This is represented on the diagram by a shift to the right in supply, toward a more socially optimal level.
Advantages of subsidies
- Subsidies can reduce the cost of a product and allow a firm to exploit economies of scale.
- This will improve long-run efficiency and competitiveness abroad.
- Consumer preferences may change as a result of a subsidy.
Disadvantages of subsidies
- Subsidies may encourage laziness from producers because they do not need to be as efficient.
- There is also an opportunity cost to a subsidy.
- Elasticity of demand determines how effective a subsidy is.
- Subsidised goods may be of a lower standard than alternatives they're trying to replace.
Minimum and Maximum Price Controls
Governments can influence supply and demand by enforcing maximum and minimum prices.
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Maximum price
- A maximum price is a policy to increase consumption levels of a good.
- If the new maximum price is above equilibrium, there will be no change.
- If the new maximum price is below equilibrium, there will be more demand but a shortage of supply, leading to excess demand.
- So although more people can now afford the good, less people can have it as the supply is restricted.
- This might lead to the good being sold in a black market.
Minimum price
- A minimum price can be used to correct failures that can happen under monopsony power.
- If the new minimum price is below equilibrium, there will be no change.
- If the new minimum price is above equilibrium, there will be less demand but increased supply, leading to excess supply.
Pros and cons of a maximum price
- Pros:
- This protects consumers from exploitation.
- It could make sure that firms are more efficient by forcing them to pay more attention to costs.
- Cons:
- A maximum price could deter firms from entering the market.
- It could also limit investment into the industry as the amount of profit firms can make is limited.
- Firms could cut costs too aggressively in an attempt to boost profit, leading to poor quality goods, etc.
Pros and cons of a minimum price
- Pros:
- By having a minimum price, suppliers can get a reasonable price for their goods.
- Cons:
- Consumers will be paying more for their goods.
- Resources are wasted when excess goods are destroyed.
- Resources are allocated inefficiently - they could have been used elsewhere instead of producing excess supply.
- Potential high opportunity cost, because governments could spend on other schemes.
Test yourself on Subsidies & Price Controls
Which of the following is a disadvantage of subsidies?
Which of the following are advantages of subsidies?
Which government policy could lead to the excess demand shown in the diagram?