Explain why governments provide subsidies.

Evaluate the effectiveness of price floors in achieving a reduction in the consumption of demerit goods.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of subsidy
• diagram showing the imposition of a subsidy leading to higher producers’ revenues (including the subsidy), lower prices and higher level of production/consumption
• explanation that governments provide subsidies to stimulate the production and consumption of merit goods (e.g. education, healthcare) and to support certain producers/consumers for political reasons
• examples of specific markets where subsidies have been provided in practice.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definitions of price floor, demerit goods
• diagram showing the imposition of a price floor, resulting in increased price and decreased quantity demanded (consumed)
• explanation that the imposition of a price floor on the market for a demerit good would increase the price and reduce the quantity demanded (and consumed) of the good, moving consumption of the good closer to the socially optimal quantity 
• examples of cases where price floors have been imposed to discourage the consumption of demerit goods
• synthesis or evaluation.

Evaluation may include:

• Consideration of the limitations of the policy: unlike indirect taxes, price floors do not increase government revenues; may lead to surpluses and attempts by the producers to sell the surpluses at a price below the legally set minimum (in parallel markets); may increase the producers’ revenues and profits (if the demand for the demerit good is inelastic).
• Consideration of the strengths of the policy: the threat of a price floor may cause the suppliers to modify the product to reduce the negative externalities; price floors may be used in cases where the local government is not legally allowed to impose indirect taxes or ban the use of the demerit good. A price floor allows government to set the price, a tax might be absorbed by abnormal profit-making producers.
• Consideration of the strengths and limitations of alternative policies such as indirect taxes and government regulations (restrictions).

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

This was a very popular question and was well done by most candidates. Clearly it is an area that is well taught, and candidates were able to present clear diagrams which accurately showed the application of a subsidy. Most candidates were also able to offer real-world example of where subsidies had been applied. Many responses confined themselves to one specific reason for subsidies being used by government. Higher-achieving responses were able to offer several reasons, and to support their explanation throughout with real-world examples. There was tendency for candidates to think in terms of specific products without much development. 

A successful avenue was to look at an industry as a whole. The dispute between Airbus and Boeing over state subsidies was usefully selected by some candidates, enabling a wider consideration of why they are given. That such example might touch on other syllabus, such as trade, does not matter as long as the question is addressed. 

A surprisingly large number of candidates confused maximum and minimum prices. Many candidates also ignored the question's specific reference to demerit goods. Significant numbers of responses identified incorrect community welfare losses, where it was presumed the government would buy the surplus of a demerit good resulting from a minimum price. Thus, they were considering the consequences for welfare, of a price support scheme usually targeted at farmers. Responses that were able to provide real-word examples in support of an analysis that examined the relative merits of price floors scored well. It was probably easier in this case to consider how alternative policies might be arguably better, such as indirect taxes.