This example illustrates an application of the

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This example illustrates an application of the general theory of second best . Essentially, the theory states that when two opposing factors contribute to efficiency losses, they can offset one another’s distortions.
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51 Corrective Subsidies: A Means of Internalizing Positive Corrective Subsidies: A Means of Internalizing Positive Externalities Externalities A corrective subsidy is similar in concept to a corrective tax. Figure 3.6 shows how a corrective subsidy for inoculations can result in the efficient output of this good. The competitive market equilibrium output would be 10 million inoculations per year at the competitive market price of $25 per inoculation. This is inefficient because the marginal social benefit ( MPB i + MEB ) at that level of consumption exceeds the marginal social cost. A corrective subsidy is a payment made by government to either buyers or sellers of a good so that the price paid by consumers is reduced. The payment must equal the marginal external benefit of the good or service. In this case, $20 is the marginal external benefit associated with each person inoculated.
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52 Corrective Subsidies: A Means of Internalizing Positive Corrective Subsidies: A Means of Internalizing Positive Externalities Externalities Suppose the government announces that it will pay each person inoculated a subsidy of $20. This subsidy adds $20 to the marginal private benefit of each inoculation. The demand curve for inoculations shifts upward from D=MPB i to D′ = MPB i + $20. As the demand for inoculations increases, the market equilibrium moves from point U to point V in Figure 3.6. At that point, the market price of an inoculation increases to $30 to cover increased marginal costs of production. However, the net price after receiving the subsidy declines for consumers. The net price is now $30 - $20 = $10 per inoculation. This reduction in the net price to consumers increases the quantity demanded to 12 million per year, the efficient output.
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53 Corrective Subsidies: A Means of Internalizing Positive Corrective Subsidies: A Means of Internalizing Positive Externalities Externalities The effect of the subsidy is to increase the benefit of inoculations accruing to those other than the buyers or the sellers of inoculations from $200 million per year to $240 million per year ($20 per person inoculated multiplied by 12 million inoculations per year). The government accomplishes this by making a total of $240 million in subsidy payments to the 12 million people inoculated each year. This is represented by the area RVXY in Figure 3.6. The subsidy is paid from tax revenues.
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54 Subsidy Payments Figure 3.6 A Corrective Subsidy 0 Price, Benefit, and Cost (Dollars) Inoculations per Year (Millions) Y 10 X D' = MPB i + $20 = MSB D = MPB i S = MSC 25 10 U 30 12 V R 45 Z
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55 Corrective Subsidies: A Means of Internalizing Positive Corrective Subsidies: A Means of Internalizing Positive Externalities Externalities Examples of corrective subsidies include the provision of certain government services at levels below the marginal cost of such services. For example,
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