6. Distortion Subsidy vs Corrective Subsidy
Based on Handwritten Notes pp. 1-2, 10 - Wheat Guarantee Price Example
Key Distinction
Corrective Subsidy
When: Positive externality exists
Result: Moves market TO efficiency
Net effect: Efficiency GAIN (+10)
Example: Vaccination subsidy
Distortion Subsidy
When: No externality exists
Result: Moves market AWAY from efficiency
Net effect: Efficiency LOSS (-875)
Example: Wheat guarantee price
Wheat Guarantee Price Example
Setup: Free market for wheat. No external cost, no external benefit. MPC = MSC, MPB = MSB.
- Supply: P = 0.5Q, Demand: P = 70 - 0.2Q
- Free market equilibrium: E1 at Q1=100, P=50 (this IS the efficient point since no externalities)
- Government sets guarantee price to support farmers
- Rule: if market price > guarantee, sell freely. If price ≤ guarantee, government buys at guarantee price
Interactive Chart
Real-Time Surplus Calculations
Why is this a LOSS? Because the market was already efficient (no externalities). The subsidy distorts the efficient allocation by encouraging production beyond Q1=100 where MSC > MSB. The DWL triangle represents pure waste.
Why does government do this? (1) Protect farmer income, (2) Achieve food security, (3) Prevent inflation in bread prices. Despite the efficiency loss, there may be equity or political reasons.