(8) - The market mechanism, market failure and government intervention in markets

Indirect taxes are taxes on expenditure. They increase production costs for producers, so producers supply less. This increases market price and demand contracts. They could be used to discourage the production or consumption of a demerit good or service. For example, the government could impose a £1 tax per packet of cigarettes. There are two types of indirect taxes: Ad valorem taxes are %, such as VAT, which adds 20% of the unit price. This is the main indirect tax in the UK. Specific taxes are a set tax per unit, such as 58p per litre fuel duty on unleaded petrol.

The incidence of tax might fall differently on consumers + producers. Producers could make consumers pay whole tax (P3 - P2), or if they feel this would lower sales + lose them revenue, they could choose to pay part of tax. Producers might pay P1 - P2, whilst consumers might pay P3 - P1. Incidence of tax depends on price elasticity of demand of good. For cigarettes, since D is fairly price inelastic, consumers might have larger burden of tax. The more inelastic the D, higher tax burden for consumer, and lower burden of tax for producer.

This should, in theory, discourage consumption of the demerit good and reduce negative externalities. Government revenue from ad valorem taxes is larger if demand is price inelastic. This is because demand falls only slightly with the tax.

Indirect taxes could reduce the quantity of demerit goods consumed, by increasing the price of the good. If the tax is equal to the external cost of each unit, then the supply curve becomes MSC rather than MPC, so the free market equilibrium becomes the socially optimum equilibrium. This internalises the externality. In other words, the polluter pays for the damage.

A subsidy is a payment from the government to a producer to lower their costs of production and encourage them to produce more.

Subsidies encourage consumption of merit goods. Includes full social benefit in market price of good. Therefore, external benefit is internalised. E.g. govt might subsidise recycling schemes so cheaper for consumers to recycle waste, which will yield positive externalities for environment. The S curve shifts to left. More of merit good is produced + price falls from P1 to P2. The vertical distance between S curves shows value of the subsidy per unit.

Consumers gain more from the subsidy when demand is price inelastic, whilst producers supply more when demand is price elastic.

The disadvantages of subsidies include the opportunity cost to the government and potential higher taxes, the potential for firms to become inefficient if they rely on the subsidy and government failure, if they subsidise less efficient industries.

The government might set a maximum price where the consumption or production of a good is to be encouraged. This is so the good does not become too expensive to produce or consume. Maximum prices have to be set below the free market price, otherwise they would be ineffective.

Suppliers have monopoly power and able to generate substantial economic rent by charging high prices The good is socially important - e.g. good quality housing is important to labour productivity and nations' health. Demand is price inelastic because good is necessary for maintaining minimum standards of living.

Add pic The free market equilibrium is at P1, Q1. If suppliers only produced Q3, some consumers would be willing to pay P2. Shaded area shows consumer surplus producers can take with higher price. Quantity of Q3 would require rationing or auctioning, since quantity D is Q2.

They prevent monopolies exploiting consumers. E.g. in EU, price caps on roaming charges are in place to make sure not too expensive for consumers to use their mobile phones abroad. Control market price, but could lead to govt failure if misjudge where optimum market price should be. Could lead to welfare gains for consumers by keeping prices low, and could increase efficiency in firms, since have incentive to keep costs low to maintain profit level.

However, it could reduce a firm's profits, which could lead to less investment in the long run. Moreover, firms might raise the prices of other goods, so consumers might have no net gain.

If supply and demand are very inelastic, then a maximum price may have little adverse impact on creating shortages. For example, if supply housing for rent is very profitable, then a maximum price will not stop landlords putting the house on the market.

The government might set minimum price where consumption or production of good is to be discouraged. Ensures good never falls below certain price. E.g. the government might impose a minimum price on alcohol, so less affordable to buy it. National Minimum Wage is an example of minimum price. Minimum prices would reduce negative externalities from consuming a demerit good, such as alcohol. Minimum prices have to be set above free market price, otherwise would be ineffective.

This minimum price will yield positive externalities of a decent wage, which will increase the standard of living of the poorest, and provide an incentive for people to work.

ADD PIC The diagram suggests minimum wage leads to fall in employment rate (Q1 - Q3). It depends on what level wage is set, though. An inelastic labour demand will mean there only small contraction in demand for labour (Q1 - Q3).

Could be costly for govt to buy surplus A minimum price guarantee acts as incentive for farmers to try + increase supply. As unintended consequence, minimum price encourages more supply than expected and cost for govt rises. This happened with EEC Common Agricultural Policy. To ensure minimum prices, govt may have to put tariffs on cheap imports - which damages welfare of farmers in other countries.

These could limit amount of negative externalities, in form of pollution, created in industries. Firms will be allowed to pollute up to certain amount, and any surplus on permit can be traded. This means firms can buy + sell allowances between themselves. E.g. there could be limit on quantity of carbon dioxide emissions released from the steel industry.

• Since govt caps number of permits, guaranteed that pollution will fall to the targets set by the government

• Govt can raise revenue by selling permits + fining firms who exceed pollution permits. This revenue could then be reinvested in green technology.

• Encourages companies to use + invest in green tech

• Firms are able to make own decisions about whether to cut pollution or buy more permits. Helps encourage efficiency

• If firms exceed permit, will have to purchase more permits from firms which did not use whole permit. This raises revenue for greener firms, who might then invest in green production methods.

• Can be expensive to monitor + police, but will only work if monitored well as govt need to impose fines to ensure firms follow regulation.

• Will raise costs for businesses, and likely these higher costs will be passed onto consumers

• May be difficult to know how many permits govt should allow

• Could lead to some firms relocating to where can pollute without limits, which reduce production costs.

• Competition could be restricted in market, if permits create barrier to entry for potential firms.

Government could provide public goods which are underprovided in free market, such as education and healthcare. These have external benefits. This makes merit goods more accessible, which might increase consumption + yield positive externalities. It could be expensive for govts to provide education, + govt will incur opportunity cost of spending their revenue.

By providing info, govts can ensure there is no info failure, so consumers and firms can make informed economic decisions. E.g. govts might make it illegal for 2nd-hand car dealers not to reveal entire history of car, so consumers know exactly what they are buying. This could be expensive to police.

Govt could use laws to ban consumers from consuming good. Also make it illegal not to do something. E.g. minimum school leaving age means have to be in school until 16, and education or training until 18. Has positive externalities in form of higher skilled workforce. If there was compulsory recycling scheme, be difficult to police + could be high administrative costs. Bans could be enforced for harmful goods, although can still be consumed on black market. Firms which fail to follow regulations could face heavy fines, which acts as disincentive to break rule. Could raise costs of firms, might pass on higher costs to Cs.

Govts intervene in markets to try + overcome market failure. Govt may also seek to improve distribution of resources (greater equality). Aims of govt intervention in markets include: Stabilise prices Provide producers/farmers with minimum income To avoid excessive prices for goods with important social welfare Discourage demerit goods/encourage merit good

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Fluctuating Prices Uncertainty leads to lack of income Low-Income elasticity of demand Positive Externalities of Farming Therefore govt may feel is case to intervene + stabilise prices. A buffer stock involve combination of minimum + maximum prices. Idea is to keep prices within target price band.

Govt policy to influence demand indirectly. E.g. putting cigarettes behind closed covers - makes it harder or less enticing for people to buy. Govt may also place flashing speed limit signs to give smiley face to drivers under speed limit, but unhappy face to drivers exceeding speed limit.

Demand may be inelastic Hard for govt to know external cost + how much to tax May encourage tax evasion - e.g. rubbish tax can encourage fly-tipping

Cost to government Subsidies may encourage firms to be inefficient because they can rely on government aid.

Minimum price for alcohol means alcoholic drink cannot be sold below certain price. Aimed at preventing sale of v. cheap alcohol by supermarkets.

The hope is that higher price will discourage binge drinking, improve health, + make people pay price closer to true social cost of alcohol.

Opponents argue is unfair and regressive price which will hurt living standards of those on low income.

Furthermore, if you wanted to increase price of alcohol - tax is better way to increase price because public will benefit from improved tax revenues.

Overconsumption of alcohol can lead to many social problems, e.g. increased crime, increased accidents. It contributes to variety of health problems e.g. premature death, cirrhosis of liver, heart disease, cancer, alcoholism, + mental problems. All these places costs on NHS, which have to be borne by taxpayer. UK's alcohol problem much worse than most European countries, e.g. France. According to ONS, 2010/11, was 11 % increase in alcohol-related (hospital) admissions giving a total of 1,168,300 admissions. This is more than 2x as many as in 2002/03 (510,700).

Academics say total deaths from "wider harms" caused to society by alcohol could reach 250,000 in England + Wales by 2019 if current trends continue. (250,000 deaths from alcohol) According to report "The personal, social + economic cost of alcohol has been estimated to be up to £55bn per year for England and £7.5bn for Scotland,"

Min price of 45p per unit would mean can of strong lager could not be sold for less than £1.56 and bottle of wine below £4.22. Research by Sheffield Uni for govt shows 45p min would reduce consumption by 4.3%, leading to 2,000 fewer deaths + 66,000 hospital admissions after 10 years. Researchers also claim number of crimes would drop by 24,000 a year. 5p makes difference. Research by Sheffield Uni shows that if alcohol priced at 45p per unit consumption drops by 4.3% - 75% greater effect than would be seen at 40p. In addition, biggest effect is amongst young 'binge' drinkers who most price sensitive. Feb 2018, Scot's govt set minimum price of 50p per unit.

It makes people pay the social cost of alcohol. The Institute for Fiscal Studies, suggests approx 70% of shop-bought alcohol is priced below the 50p a unit. It can particularly discourage young drinkers from overconsumption It will have a positive effect on more 'upmarket' alcohol brands and pubs. People may go out to pub and spend there, rather than 'preloading' on cheap alcohol from supermarkets. Reduce consumption Make individuals pay price closer to SMC Reyes costs to police / health care

Some politicians argued would reduce living standards for those on low incomes. Min price is highly regressive + will affect those on low incomes most. Already substantial tax on alcohol. Higher min price could encourage people to switch to illicit 'home brews' + replacement alcohol. Potentially dangerous as leaves people exposed to alcohol of unknown quantity and composition. Easy way for supermarkets + firms to increase profits. D for alcohol is price inelastic - if all firms forced to increase prices, easy way to increase prices + profits Govt better off just increasing tax on alcohol so society pockets extra cost rather than supermarkets and alcohol producers. Then tax revenue raised used to fund cost of treating alcohol-related diseases.

Simple S + D model suggests min price above equilibrium could cause surplus (S greater than D). Did occur with min prices of CAP. However, with alcohol pricing, this wouldn't occur. S and D are both v. inelastic, supermarkets would just put up prices

Externalities in alcohol can lead to market failure and social inefficiency. This provides case for govt intervention. To show negative externalities of alcohol, we could either show: Negative externalities of consumption. Negative externalities of production. If you consume alcohol, are costs to rest of society - drunkenness, lost productivity, cost of policing, costs of health care. SB is less than PB.

ADD PIC In free market, outcome would be Q1, but this is greater than socially efficient level - there is overconsumption. At Q1 - SMC>SMB If govt set min price of P2, would reduce D to Q2 where SMB = SMC and outcome is socially efficient.

Another way of thinking of external costs of alcohol is that as alcohol is produced, is a cost to rest of society not met by individual drinker - therefore SMC of drinking is greater than PMC. Arthur Pigou used alcohol to illustrate concept of externalities in The Economics of Welfare (1920). A Pigovian tax is tax which makes individuals pay full SMC.

ADD PIC Free market equilibrium of Q1, P1. But social efficiency occurs at Q2,P2 A minimum price of P2 would have the same effect of reducing output to the socially efficient level of Q2.

If firms have monopoly power, can charge high prices to consumers - higher than marginal cost of production and higher than in competitive market. Max price can be way of reducing 'monopoly prices' + also increase allocative efficiency.

If rents were v. high, may cause investors to concentrate on building new houses + ignoring other aspects of economy. However, excess of house-building could contribute to bubble in home-building - which leaves market vulnerable to correction in prices. E.g. housing bubbles in Ireland + Florida pre-2007 credit crisis. Max price limits resources flowing to houses + enables more balanced economy.

ADD PIC If S v. inelastic, then max price will not reduce S of good, therefore, there will be no fall in Q supplied. In this example, is max price, but because S + D are both price inelastic, is only small shortage of rented accommodation. S for rented accommodation can be quite price inelastic in real world because landlords don't have many alternatives to renting property.

Max price distorts market and leads to disequilibrium. D is greater than S meaning many consumers will be unable to get product at all. Cheap rents are no good if it leaves many people homeless.

Because of shortage, creates incentive to develop a 'black market' where people illegally trade good. People could buy good at low max price and then resell to those customers who were unable to buy. This is potentially quite lucrative as some out customers who missed out may be willing to pay v. high price.

People will end up queuing to try and get good before sells out. Will encourage people to spend longer + longer in queues before it runs out. Time spent queuing represents sig cost in terms of time

The market will become less profitable for firms. In long-term, this may lead to less investment and also decrease S in the long-term. E.g. rent controls may be way to deal with short-term problem of expensive housing. But, reducing rents will discourage some landlords from letting out property. It may also discourage people from building houses.

The most effective way to implement max prices would be to also try + deal with S. If housing too expensive, long-term solution is to build more affordable housing - and not rely on max prices. Max prices may be most useful in case of monopoly who is both restricting supply + inflating prices. An alternative may be to reduce power of monopolies; though, in some industries, not possible - so max prices will be most effective.

When inflation is increasing, the monetary authorities can set a legal price limit on the amount prices can rise. In theory, this will limit price increases and keep inflation under control without resorting to higher interest rates.

If prices are rising due to bigger profit margins (e.g. firms have monopoly power) then setting limits on price increases can ensure prices don't rise, without causing a shortage of the good.

If prices are increasing and supply is inelastic, then price controls should not affect supply. E.g. if the supply of housing is fixed, rent controls can reduce prices without reducing supply.

In times of war and rationing, price controls aim to stop firms profiting from the shortage and keeping prices affordable for all consumers, otherwise, the price of limited goods, such as food will skyrocket with many consumers being unable to afford them. In US, 1941 - 1947, Office of Price Administration was responsible for keeping inflation under control by limiting prices. This period of price controls did help to reduce inflation compared to WW1. There were also price controls in Nixon administration + Korean War.

Price controls don't have to be for all goods, but can be focused on those considered essential. Price controls best used for specific time period, e.g. when is pent-up D and S chain shortages. E.g. at end of war or in 2022 at end of Covid pandemic.

Price controls do nothing to tackle the underlying reason for inflation. E.g. if inflation is caused by excess demand, the demand will still be there, but the price controls will only make goods more attractive. If inflation is caused by a shortage of goods and cost-push factors, the shortage is not resolved by keeping price limits lower.

Price controls can reduce the incentive for firms to increase supply. E.g. if prices are rising due to supply bottlenecks. The rise in prices will create an incentive for firms to increase supply. However, if govt pursue price controls, then this incentive to increase supply is reduced. Therefore, far from solving the problem, price controls can make the shortage last for longer.

Shortage. The price controls of the 1970s led to queues and shortages of meat and gasoline.

Wasteful activity. Price controls can lead to wasteful economic activity as people wait in line to get the limited goods. This increases the cost of the good. If you earn $15 an hour but spend 30 minutes in a queue, the gasoline is an extra $7.50

Bureaucracy and interference. With price controls, there is wasteful spending on government bureaucracy. The WWII price administration office gained 15,000 employees and firms complained that the agency was not just setting prices but increasingly being descriptive of which goods they could sell.

Black market - another problem of price controls is that it is likely to cause growth in the underground economy. When demand is artificially reduced, there will be a temptation for people to buy at an artificially low price and sell at a higher price on the black market to those who cannot queue.

Lower output. With price controls, firms will have less incentive to produce goods, leading to lower employment. A study by Paul Evans found that WWII price controls were successful in keeping prices 30% lower than otherwise, but with a 12% reduction in employment and 7% lower output. See Journal of Political Economy (1982)

Price controls more effective if combined with rationing, but rationing itself has costs and difficulties. Price controls targeting to v. specific cases of price gouging can be more effective. Generally, price controls will have unintended consequences, most notable is keeping prices lower will lead to lower supply and shortage of good may last for longer.

Nudge theory suggests consumer behaviour can be influenced by small suggestions + pos reinforcements. Proponents of nudge theory suggest well-placed 'nudges' can reduce market failure, save govt money, encourage desirable actions + help increase efficiency of resource use. Critics argue nudges can be misused + become form of social engineering or way to encourage consumers to buy goods don't really need. With Richard Thaler being awarded Nobel Prize in economics for work on behavioural economics, nudges likely to become increasingly common in everyday life.

In UK, Behavioural Insights Unit was set up to use behavioural economics in order to improve choices. Their remit includes: making public services more cost-effective + easier for citizens to use; improving outcomes by introducing a more realistic model of human behaviour to policy, and wherever possible, enabling people to make 'better choices for themselves'.

If you go to fast-food restaurant, servers are trained to 'up-sell' - this means they offer extra options to go with the meal. Often it is 'drinks, extras and deserts' which are the most profitable part of the meal. If you buy a coffee, and a barista offers a pastry as well - we are more likely to buy the pasty when it is offered as a suggestion.

To encourage healthy eating, healthy options could be made more easily available, e.g school lunches could be carefully monitored - reducing the number of unhealthy options. This is related to the concept of 'choice architecture' - the idea that if goods are presented in a different way, it can help 'nudge' people's consumption to the desired option.

A powerful way to encourage take-up rates of 'desirable options' is to set the desired outcome as the default option.

Economists Richard Thaler and Shlomo Benartzi developed a programme called: Save More Tomorrow™. Idea is to nudge people into taking private pension plans by using behavioural economics. It uses default choice of enrolling people in pension scheme, with added proviso they only start off making small contributions. Only when wages rise, will contributions automatically increase. It has seen saving contributions quadruple at companies which use it. The way it designed makes the scheme very attractive, and few people choose to reject the offer.

To discourage unhealthy eating, the amount of sugar can be included prominently on the packaging to make consumers think twice about purchasing. Would you be less willing to bu a muffin, if it is labelled as 450 calories?

Technology can be left to make better decisions for us. E.g. when UK behavioural team tried to reduce energy use in heating homes through education, they had little effect. But, when trialled use of automated technology - it was much more successful. The Nest Learning Thermostat uses sensors and machine-learning to understand the thermal properties of your building and your occupancy habits. It led to a 6% fall in energy use.

One of strongest nudges is to show feedback from peers. Positive reviews displayed prominently - play significant role in encouraging people to buy. Companies may display favourable reviews next to their product. Govt may also show examples of people who have benefited from certain schemes (or show images of people caught and then named and shamed for tax evasion/benefits fraud.) To reduce missed hospital appointments, most hospitals send text reminders on day. Studies suggest changing words of SMS can influence how successful these text messages are. E.g. if text messages mention direct costs to NHS for missing appointment (£160) - it helped reduce missed appointments from 11.1% to 8.5%. A study found that if students are sent motivating text messages, attendance rates improved.

Banks encouraged sale of payment protection insurance for pensions and other financial services. They were sold as an essential package for the product. But, in reality, the cost and profit margin for the bank was never fully explained. The government later made banks liable for evidence of mis-selling.

Some firms offer a free subscription for a month. But, to get the free subscription it is necessary to give credit card details and pay for a month upfront. To gain free subscription it is necessary to ring and cancel before the end of the month. But, because of the inconvenience, many consumers may end up paying more than expected.

If you try to cancel certain services, e.g. internet provider. To cancel you have to ring up and a dedicated salesperson will try and discourage consumption - through offering a special discount for next three months. The strong sales pitch may nudge consumers into not changing.

In the early 2000s, many US consumers were offered special discounts on mortgages. It made mortgages very cheap for the first year or two - to encourage people to get the mortgage. But, after that introductory period, interest rates went up to normal levels - causing a big increase in the cost of mortgage payments. Many people defaulted on mortgages because they didn't fully realise how much mortgage payments would rise after the end of an introductory period. This proved a cause of the credit crunch.

There is difference between nudging behaviour and compelling choice. A good nudge may be considered to be one which encourages certain choice, but is still: Transparent - Make the nudge clear and obvious, not hiding costs / other options. Choice is retained - with consumer able to make the final choice. Good reason to believe that nudge is warranted, e.g. strong health costs of smoking/eating too much sugar. Nudges may not be enough. To reduce smoking rates, we need policies which really tackle core problems. This may require - higher taxes, restrictions on places where you can smoke.

A carbon tax aims to make individuals and firms pay the full social cost of carbon pollution. In theory, the tax will reduce pollution and encourage more environmentally friendly alternatives. However, critics argue a tax on carbon will increase costs for business and reduce levels of investment and economic growth

Makes polluters pay external cost of carbon emissions In theory, enables greater social efficiency, as we pay full social cost Raises revenue which can be spent on mitigating effects of pollution Encourages firms and consumers to look for alternatives e.g. solar power Reduces environmental costs associated with excess carbon pollution

Business claim higher tax can discourage investment and economic growth May encourage tax evasion - firms polluting in secret to avoid tax It can be difficult to measure external costs - and how much tax should actually be Administration costs in measuring pollution and collecting tax Firms may shift production to countries without a carbon tax

The purpose of carbon tax is to internalise externality. What this means is that final price of the good should include the external costs and not just the private cost. It is similar to the 'polluter pays principle.' - which was incorporated into international law at the 1992 Rio Summit. It simply means those who cause environmental costs should be made to pay the full social cost of their actions.

Add pic This diagram shows that in a free market (without any tax), we get overconsumption (Q1) of carbon, leading to a welfare loss to society.

Add pic The tax shifts the supply curve from S to S2. With the tax, consumers now face the full social cost (SMC). Quantity falls from Q1 to Q2. Q2 is socially efficient because social marginal cost = social marginal benefit.

In theory, a carbon tax could be revenue-neutral. This means the tax raised from taxing carbon emissions can be used to reduce other taxes. There should be no overall increase in the tax burden. The aim is to increase social efficiency by making people aware of the full social cost.

A higher price of carbon emissions will encourage firms and consumers to develop more efficient engines or alternatives to consuming carbon emissions. E.g. with carbon taxes, will be more efficient to develop hydrogen engines or solar power. It might encourage more people to cycle or walk to work. This would have health benefits such as the lower risk of a heart attack. This could make it more feasible to generate electricity from green sources (e.g. solar power). If we develop more green sources it will also make us less reliant on oil. It will help make the transition to a post-oil economy easier.

The revenue raised from a carbon tax could be used to subsidise alternatives such as green electricity or the revenue raised could be used to repair the damage caused by environmental pollution. Alternatively, a higher carbon tax could be used to reduce other taxes, such as VAT.

Leads to a socially efficient outcome. It makes people pay the social cost and overcomes the excess consumption we see in a free market. Improves the environment. With higher taxes, firms will reduce pollution and look for alternatives which have a lower environmental impact. For example, it will make solar power even more competitive than traditional fossil fuels.

Countries which have implemented carbon taxes have seen encouraging results - resulting in lower carbon emissions than would otherwise have occured, and in many cases substantial falls in CO2 emissions. E.g. Sweden intro carbon tax of €33 per tonne in 1991. Over time, the tax was increased to €120 per tonne. (Some sectors like manufacturing, agriculture and forestry, received a discounted rate). Since mid-1990s emission levels in Sweden has fallen by over 20%, making it one of more successful EU countries in reducing emissions - despite period of strong economic growth. This shows carbon tax can play role in enabling lower carbon emissions, without holding back economic growth and rising living standards

UK - coal use fell sharply after intro of carbon tax of around $25 per ton in 2013. In UK greenhouse gas emissions have fallen to lowest level since 1890. British Colombia intro scheme in 2008 to charge levy on carbon. In 1st 4 years of scheme 2008 - 2012, Karen Tam Wu of Pembina Institute said "We saw fossil fuel consumption decrease by more than 17% and in the rest of Canada fuel consumption increased by more than 1%," Canada has implemented an ambitious carbon pricing tax (named pollution pricing). In Canada, it has led to higher energy bills, but 90% of proceeds are given to households in the form of tax rebates. The full success of the scheme is not fully evaluated, but it retains popular support

Production may shift to countries with no or lower carbon taxes. (so-called 'pollution havens') This can give developing countries an incentive to encourage production processes which cause pollution, i.e. there is 'outsourcing' of pollution.

If demand is price inelastic, the tax may have to be very high to reduce demand significantly. In the short term, firms may not feel they have many alternatives. Though, over time, demand will become more elastic as more alternatives are generated.

Consumers dislike new taxes and often don't believe that they will be 'revenue neutral'. This is not an economic argument, but it is a political reality and explains why it is often difficult to implement.

A global carbon tax may curtail economic activity in the poor developing world because they can't afford the small increase in energy costs, but the developed world may simply be able to pay. There may be a need for a carbon tax to reflect different abilities to pay.

To be successful, it depends on how proceeds of carbon tax is distributed. In British Colombia, Canada, the main proceeds of Carbon pricing go directly to firms households - making the carbon tax quite popular amongst important political constituencies. By contrast, Australia's short-lived carbon tax 2012-14 suffered from lack of political understanding and poor communication about who benefitted from it.

Add pic The government will have to pay for the subsidy by taxes. The cost of the subsidy in this example is £14 x 140 = £1,960

If demand is elastic, then a subsidy causes a bigger percentage rise in demand. There is only a small fall in price. In this case, producers benefit from the subsidy because their producer surplus increases more than consumer surplus If demand is price inelastic, then a subsidy causes a substantial fall in price, however there is only a small increase in demand.

Add pic A government subsidy causes an increase in consumption and increases output to a more socially efficient level.

It would be expensive; govt would have to raise significant amount of tax revenue. When govt subsidises firms, reduces incentives for firms to cut costs. For this reason, argued that govt should avoid subsidising firms unless there is a clear social benefit to subsidising firms. Milton Friedman made point "There is nothing so permanent as a temporary government program." The point is that once pressure group starts receiving subsidy, it becomes v. difficult politically to remove that subsidy. To get elected politicians need to promise to keep subsidy, even though there is net welfare loss. E.g. temporary US agricultural subsidies introduced in late 1920s and early 1930s, which have grown in cost and influence and v. difficult to remove.