Answers: Government Subsidy

Question 1

1. Government subsidy distorts market prices, which results in inefficiency and resembles externalities. The use and production of goods do not reflect a real economic cost, causing a negative externality. The use of subsidy results in production externality whereby products in the market do not bear the full cost of production. Therefore, missing production cost is transferred to another individual or entity. Similarly, the use of these goods or services leads to two-sided consumption externality since when one person using the product does not pay the full cost for its utilization, another business or individual has to be taxed higher to bridge this gap. Lastly, subsidy reduces government proportion of taxes on the same product. It is a trade-off between government income and expenditure. Hence, key government functions consist in security funding and infrastructure development. The application of subsidy affects other sectors with efficient systems.
2. Government subsidy may not cause a negative externality if it does not lead to market inefficiency. The business environment is different for various industries. Therefore, the cost of production is also different while some businesses are riskier than others. Subsidy offers production lifeline for goods that are important to the economy and the production of which is inefficient due to market anomaly. The products suffer from non-excludability and non-rivalry since they are considered either public goods or basic commodities. Moreover, subsidy can be used when the cost of production is high and no business is willing to engage in its creation. The subsidies lower the costs of production acting as incentives for producers to stay in business. Lack of these products makes markets inefficient for allocating power or transport systems. Finally, subsidy is a solution to market inefficiency when other policies fail and cause unemployment. To counter unemployment, subsidy can help create new jobs by reducing the cost of doing business.
3. On the one hand, government subsidy can serve as a remedy for the negative externality only if the effect of the subsidy is positive. If the subsidy itself is a negative externality, it fails to counter the market inefficiency. It can result even in a greater failure of the system. Therefore, forces of demand and supply do not achieve equilibrium, increasing market inefficiencies. On the other hand, government subsidy has the ability to make a system more efficient. The subsidy improves market inefficiencies, providing solutions to negative externalities. In this case, subsidy streamlines negative externality. If subsidy has positive results, it is able to solve the negative externality. Nonetheless, if it results in market inefficiencies, it worsens negative externalities.

Question 2

a.

1. The firm as a unit of production refers to the structure where production decisions are made. It is the smallest unit of production in a business. In this case, there is separation between the totality of the firms and production since numerous activities take place under a firm name, but main emphasis is put on processes directly involved in production.
2. The firm as a pricing and branding unit is related to the types of firms in an industry. The industry is considered as a group of firms producing similar or differentiated products for the same market. Therefore, the firm creates a unique product under its brand and provides a price based on its production model.
3. Finally, the firm as a unit of internal control refers to the organization structure adopted for business. It can be a corporation, partnership or sole proprietorship. The chosen structure comes with simplicity as the size reduces.

b. The application of information has the ability of changing a firm’s size no matter the approach attributed to it. Information as an economic good is useful, valuable and transferable as either private or public good depending on the accessibility status. The internet facilitates the availability of information, making it easily transferable and free. However, in some instances, subscription may be required to obtain the information. The firm as a production can capitalize on the availability of information to improve and expand its operations. Information available on the internet can be applied in business for operations targeting efficiency. This is the application of technologies in business based on best practices and related case studies. The firm, as pricing and branding unit, uses the information and the internet as a competition tool. Industry decisions have to be made to counter what other competitors are doing in the market. Real-time information on pricing and rebranding strategies created by other firms is readily available on the internet as either new company portal or social media platforms. Finally, the firm as a unit of internal control information improves internal control since the internet lowers the cost of communication between heads of organizations. Equally, it improves the pace of data exchange between internal organs through real-time information sharing. Digital technologies allow reception of instance feedbacks. Whereas a positive approach influences firm sizes, it is also likely for the internet to break a firm size. This can occur because of applying wrong information or revealing the business strategy of the firm.

Question 3

1. The police provide services of the security sector to maintain law and order in society. The sector chooses both male and female representatives from general public after which government makes investments in their training. In other instances, personnel are also obtained from the military. The inefficiencies of police work involve corruption, racism, excessive violence, and negligence or incompetence in investigating crimes. It is widely known that the main reasons for these inefficiencies are poor compensation and the risks, such as instant death, involved in police work. As a result, the police attempt to make as much as they can to sustain their lives and to cover any work-related hazard. Police work is evaluated by successful performance of maintaining law and order. Attention is paid to number of arrests, effective prosecution and dedication to the job, for instance, risking one’s life to save other officers. Through the supervisor, the police are rewarded with a higher rank that comes with better compensation. Compensation in the police is rank-based since higher ranks predetermine better compensation. Apart from personal effectiveness, orders from the supervisor either motivate or discourage individual police work.
2. The interest of the police and government conflict: The police are interested in their lifestyle as well as the compensation sufficient to maintain this lifestyle. On its side, the government is interested in maintaining law and order. Therefore, within the moral hazard structure, the police are required to observe law and order on behalf of the government. The police should risk it all for the obligation attached to them. However, since the government cannot fully evaluate police work, the police can intentionally sleep in their workplaces and get away with their pay, claiming it is difficult to reduce crime by 100%. In this case, the moral hazard guarantees pay since the option of failure is inevitable. The private sector provides the principal-agent problem where the police are agents and the government is the principal. In the government, principal should offer compensation that is higher than other jobs’ salary. As a result, the employees (police), who are agents, do not have a reason not to accomplish what is expected of them. Losing their jobs would mean losing a great opportunity. Hence, the tool is used to prevent shirking. Shirking is intentional underperformance by employees.

The applications of moral hazard and principal hazard problem increase government expenditure since the police have to be paid more salaries. An increase in government expenditure further translates in higher taxes within the general economy, the main target of which is income tax for individuals and companies. Thus, there is an enhanced cost of production that leads to unemployment and increases demand-side inflation since the effective income of police is advanced.

   3. Adverse selection originates from information asymmetry where one party is responsible for more information compared to the other. The problem of security is important for the government since it is meant for the good of the public. Adverse selection means that the government or police have more information on security and can advance their interest at the expense of the other. This explains the low compensation and corruption between the police and the government. Therefore, the government introduces incentives, such as insurance cover or higher compensation for performing officers. Economically, the counter strategy raises government expenditure, which is not good for the economy. Hence, other benefits, such as patriotism and awards are used. The police are advised that their careers are national responsibilities that are important for their country. As such, the service cannot be quantifiable in economic terms, and the job takes a social responsibility. The rationale is that security keeps governments in power. Otherwise, no government exists in a state of lawlessness, justifying information asymmetry. In the private sector, employees are rewarded selectively based on performance. In security sector, police would give officers cold shoulder since teamwork is compared to individual competition.

Question 4

Case B

1. The market for aluminum represents a private good. Electricity and flood control are public goods. When purchasing aluminum, one pays for the economic costs that are directly related to production. The social costs are not included in the pricing, but it involves pollution costs in order to restore the environment. The production of electricity is associated with its sensitivity. Governments produce it due to its capital outlay. The sale of electricity is set to reflect economic costs of production, paid uniformly for companies and households. The social costs on salmon effect are considered in the pricing. Electricity is considered as a social good since it is not sold for profits and its production is vital for other social functions, such as saving salmon population. The price of salmon represents an economic good. It only suffers from over-extraction that is a negative externality of its production. Living in the floodplain makes one to forgo both economic (private) and social costs that are reflected in the dam. It is subject to usage of electricity. The existing model is increasing total private surplus since only economic costs are considered while public surplus is lowered. Social costs are borne by every individual, including non-consumers of the products.
2. Pollution, over-extraction and consumption of salmon or stay in an island can be subjected to transferable transaction costs. These social costs can be added to the private costs and borne by customers, which can be alluded by Coarse-like Theorem. Users will understand that they are paying more for aluminum due to environmental effects. The price of salmon will increase when the number of stocks reduce due to fewer expensive fishing contracts. Equally, the government can introduce a flood levy for enjoyed dam benefits. The conflicts between the usages of products are offset by higher costs of consumption. The flood levy is the most unrealistic because of non-excludability. The most sustainable way to price the levy is whether it is on households or land coverage. The cost of collecting the levy and enforcing adherence can be high.
3. Rationally, increasing the price of electricity will enhance the price of the commodity. This will result in reduction of total surplus since all costs are reflected in the price. Electricity will no longer be cheaper. The market will be efficient since electricity is charged at market prices. Hence, production will be a true reflection of the total costs. Higher price acknowledges the negative externalities, pushing prices to be equal to the true cost of production. It defines social costs as a cost of production.

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