ChainWhat it assumes · how to break it
Start
The government subsidises an industry, for example guaranteeing a price to renewable electricity generators or paying operating subsidies to transport companies.
1
As a result, part of producers' revenue comes from the government rather than from customers, so the price no longer reflects the full cost of supply.
distortion of price signals
distortion of price signals
Assumes: The subsidy is open-ended.
But: A time-limited subsidy, such as early support for a new technology, ends once its costs fall.
2
This means firms have less incentive to cut costs or innovate, and inefficient firms stay in the market.
productive efficiency · allocation of resources
productive efficiency · allocation of resources
Best link to attack
Assumes: Subsidised firms face little competition for the subsidy.
Assumes: Subsidised firms face little competition for the subsidy.
But: When subsidies are awarded by competitive auction, as with UK Contracts for Difference for renewable electricity, firms must bid low to win them.
3
Consequently, the subsidy becomes hard to remove, because firms, workers and users lobby to keep it.
lobbying · political pressure
lobbying · political pressure
Assumes: The groups that benefit are well organised.
But: A subsidy written into law with a fixed end date is harder to extend.
4
Therefore, resources stay in the subsidised activity after its external benefit has fallen, or the subsidy is larger than the external benefit, causing a net welfare loss: government failure.
government failure · net welfare loss
government failure · net welfare loss
Assumes: The subsidy outlasts or exceeds the external benefit.
But: If the external benefit is large and lasting, as with cutting carbon emissions, a long-running subsidy can still be justified.
End
The subsidy can misallocate resources and create a net welfare loss, which is government failure.
Evaluation chain
- E1However, whether the subsidy weakens efficiency depends on how it is allocated.
- E2When subsidies are awarded through competitive auctions for a fixed period, firms must bid low to win them.
- E3As a result, firms keep an incentive to cut costs, and the support needed per unit can fall over time, as it did in early offshore wind auctions.
- E4So a well-designed subsidy can avoid much of this government failure; the risk is greatest with open-ended subsidies to established firms.
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Questions this answers
- Explain how a subsidy might lead to government failure.
- Assess whether subsidies for renewable energy are likely to cause government failure.
- Evaluate the view that subsidies are less effective than taxes in correcting market failure.
Diagram
MPB, MSB and supply. Draw the subsidy larger than the marginal external benefit at Q*, so output rises beyond Q* and a new welfare loss triangle appears between Q* and the new output.
Reverse and related
Ending the subsidy → market discipline returns, but the external benefit is again underprovided.