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  2. Explain how a subsidy might help reduce inefficiencies in the presence of externalities. In your answer, provide an example for when the use of subsidies might be appropriate and discuss what the optimal amount of the subsidy should be.

Explain how a subsidy might help reduce inefficiencies in the presence of externalities. In your answer, provide an example for when the use of subsidies might be appropriate and discuss what the optimal amount of the subsidy should be.

Part Three: Analytical Questions (50 marks total)

 

11. Externalities:

Consider a free market with demand equal to Q = 72 – 2P and supply equal to Q = 24 + 4P.
(10 marks)

a) What is the value of consumer surplus? What is the value of producer surplus? (2 marks)

 

b) Now the government imposes a £3 per unit subsidy on the production of the good. Why is there a deadweight loss associated with the subsidy, and what it the size of this loss? (4 marks)

 

c) Explain how a subsidy might help reduce inefficiencies in the presence of externalities. In your answer, provide an example for when the use of subsidies might be appropriate and discuss what the optimal amount of the subsidy should be. (4 marks)


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