A subsidy is an amount of money that the government gives to the producers or the suppliers of goods and services in an economy to encourage them either to produce more and to reduce price. Subsidies comes under fiscal policy.




Incidence of subsidies

This means who gets the benefits of subsidies. When the subsidy is given, it encourages the producers to produce more and hence the supply curve shifts to the right. Therefore the price moves down and the quantity demanded and supplied also increases.

However, we have to note that the price reduced will not be as much as the per unit spent by the government on the production. A part of it also will be enjoyed by the producers. Suppose the price of a gallon of milk was $3.5. The government decides to give a subsidy of $1 per gallon. Can we expect the price of milk to come down to $2.5 per gallon? Usually No!

In the diagram, the area in blue is the total benefit gained by the producers due to the subsidy. The area in green shows the total benefits gained by the consumers due to the subsidy.

A subsidy is usually given for the goods which are essential, such as staple food.

Giving subsidies also incurs a dead-weight loss, which is represented by the pink triangle on the 2nd diagram.

Tax ( Direct and Indirect)

A tax is a financial charge imposed upon an individual or legal entity by government to fund various public expenditures.Tax is a kind of money which it is the legal duty of very citizen of a country to pay honestly. It may be levied on income , property and even at the time of purchasing a commodity.a failure to pay tax is usually punishable by law.

Types of taxes

The most fundamental classification of taxes is based on who collects the taxes from the tax payer.there are two types of taxes direct and indirect taxes.

  • Direct Taxes

that are directly paid to the government by the taxpayer. It is a tax applied on individuals and organizations directly by the government e.g. income tax, corporation tax, wealth tax etc.

  • Indirect Taxes

are applied on the manufacture or sale of goods and services. These are initially paid to the government by an intermediary, who then adds the amount of the tax paid to the value of the goods / services and passes on the total amount to the end user. Examples of these are sales tax, service tax, excise duty etc.

impact and incidence of taxes:

Impact of taxation refers to the immediate burden of the tax. The impact of a tax is the immediate result of the imposition of a tax on the person who pays it in the first instance.

Incidence of a tax is the settlement of the tax burden on the ultimate tax-payer. The incidence of a tax refers to the money burden of a tax on the person who ultimately bears it. The incidence of a tax remains upon that person who cannot shift its burden to any other person.

In short, we can say , the impact of taxation is on the producer while incidence of taxation on the consumers. The impact of tax can be shifted while incidence of tax cannot be shifted.

Effect of Taxes on Supply and Demand

Taxes reduce both demand and supply, and drive market equilibrium to a price that is higher than without the tax and a quantity that is lower than without the tax.Tax authorities usually require either the buyer or the seller to be legally responsible for payment of the tax. Tax incidence is the way in which the burden of a tax is shared among the market participants. Taxes will typically constitute a greater burden for whichever party has a more inelastic curve – e.g., if supply is inelastic and demand is elastic, the burden will be greater on the producers.


Suppose that a state government imposes a tax upon milk producers of $1 per gallon.e original price for milk was $2 per gallon. After imposition of the tax, the supply curves shift up and to the left. Consumers pay $2.60 per gallon. Sellers receive $1.60 per gallon after paying the tax. So sixty cents of the tax is actually paid by consumers, while forty cents is paid by the milk shown in the figure.

Incidence of Tax


The triangle ABC above represents the dead weight loss due to taxation, which occurs because now there are fewer mutually beneficial exchanges between buyers and sellers. Dead weight loss stems from foregone economic activity and is a loss that does not lead to an offsetting gain for other market participants; it is a permanent decrease to consumer and/or producer surplus.

Specific and ad valorem taxes:

There are two types of indirect tax; specific and ad valorem.

  •  A specific unit tax

A unit tax is a set amount of tax per unit sold, such as a 10p tax on packets of cigarettes.

  • An ad valorem tax

an ad valorem tax is a percentage tax based on the value added by the producer. For instance, if the market value of a 2,000 square-foot home is $100,000, the ad valorem tax levied will be based solely on the home’s $100,000 value, regardless of its relative physical size. Municipal property taxes are an example of an ad valorem tax. One advantage of ad valorem taxes is that the tax revenue to the government can rise automatically as the economy grows. This means that the tax rate does not need to be adjusted frequently, as in the case of specific unit taxes, such as duties on cigarettes and alcohol.

The imposition of either type of indirect tax has an effect similar to a rise in production costs. This means that a firm’s supply curve will shift up vertically by the amount of the tax.

A specific unit tax

A specific unit tax will shift up the supply curve by the full amount of the tax, so that the new curve is parallel to the original one, as shown.


An ad valorem tax

The imposition of an ad valorem tax will shift up the supply curve by a certain percentage, meaning that the new supply curve will not be parallel to the original.


Average and marginal rates of taxation:


An average tax rate is the ratio of the total amount of taxes paid to the total tax base (taxable income or spending), expressed as a percentage.In a proportional tax, the tax rate is fixed and the average tax rate equals this tax rate. In case of tax brackets, commonly used for progressive taxes, the average tax rate increases as taxable income increases through tax brackets, asymptoting to the top tax rate. For example, consider a system with three tax brackets, 10%, 20%, and 30%, where the 10% rate applies to income from $1 to $10,000, the 20% rate applies to income from $10,001 to $20,000, and the 30% rate applies to all income above $20,000. Under this system, someone earning $25,000 would pay $1,000 for the first $10,000 of income (10%); $2,000 for the second $10,000 of income (20%); and $1,500 for the last $5,000 of income (30%). In total, they would pay $4,500, or an 18% average tax rate.

The average tax rate is calculated by dividing the total income taxes paid by your total income.

total income taxes paid
average tax rate (ATR)     =                  —————————
total income



A marginal tax rate is the tax rate an individual would pay on one additional dollar of income. Thus, the marginal tax rate is the tax percentage on the last dollar earned. In the United States in 2013, for example, the highest marginal federal income tax rate was 39.6%, applying to earnings over $400,000. Earnings under $400,000 that year had a lower tax rate of 33% or less.

Proportional, Progressive and Regressive taxes:

Regressive Taxes

Under a regressive tax system, individuals and entities with low incomes pay a higher amount of that income in taxes compared to high-income earners. Rather than implementing a tax liability based on the individual or entity’s ability to pay, the government assesses tax as a percentage of the asset that the taxpayer purchases or owns.

For example, a sales tax on the purchase of everyday products or services is assessed as a percentage of the item bought and is the same for every individual or entity. However, a sales tax of 7% has a greater burden on lower-income earners than it does on the wealthy because the ability to pay is not taken into consideration. Regressive taxes include real estate property taxes, state and local sales taxes as well as excise taxes on consumables such as cigarettes, gasoline, airfare or alcohol.

Proportional Taxes

A proportional tax system, or a flat tax system, assesses the same tax rate to taxpayers regardless of income or wealth. It is meant to create equality between marginal tax rate and average tax rate paid. Under a proportional tax system, individual taxpayers pay a set percentage of their income regardless of total income earned.

For example, an income tax of 10% that does not increase or decrease as income rises or falls results in a proportional tax. In this example, an individual who earns $20,000 annually pays $2,000 under a proportional tax system, while someone who earns $200,000 each year pays $20,000 in taxes. Some specific examples of proportional taxes include per capita taxes, gross receipts taxes and occupational taxes.

Progressive Taxes

The current federal income tax is a progressive tax system, in that the proportion of tax liability rises as an individual or entity’s income increases. Tax burdens are meant to be more of an imposition to wealthy, high-income earners than they are to low- or middle-class individuals.

Under a progressive tax system, taxes assessed on income and business profits are based on a progressive or increasing tax rate schedule. Marginal tax rates under a progressive tax system are often higher than the average tax rates that are paid. Estate taxes are another example of progressive taxes, as a greater burden is placed on wealthy individuals.

the Canons of Taxation:

A tax has no connection with the benefit received by the payer. Also, the charge is compulsory.Hence in distributing the burden of taxation, a person’s share cannot be decided with reference to the benefit derived by him.

Adam Smith laid down four principles to guide the taxing authority.

Adam Smith’s Canons:

The principles or canons of taxation enunciated by Adam Smith were so important that they have become classic.

They are:

  • Canon of Equality:

“The subjects of every State,” Smith asserted, “ought to contribute towards the support of the Government as nearly as possible in proportion to their respective abilities, that is, in proportion to the revenue which they respectively enjoy under the protection of the State. In the observance or neglect of this maxim consists what is called the equality or inequality of taxation.” Equality here does not mean that all tax-payers should pay an equal amount. Equality here means equality or justice. It means that the broadest shoulders must bear the heaviest burden.

  • Canon of Certainty:

Adam Smith further said, “The tax which each individual has to pay ought to be certain and not arbitrary. The time of payment, the amount to be paid ought all to be clear and plain to the contributor and to every other person.” The individual should know exactly what, when and how he is to pay a tax otherwise it will cause unnecessary suffering. Similarly, the State should also know how much it will receive from a tax.

  • Canon of Convenience:

Smith wrote, “Every tax ought to be levied at the time or in the manner which it is most likely to be convenient to pay it.” Obviously, there is no sense in fixing a time and method of payment which are not suitable. Land revenue in India is realised after the harvest has been collected. This is the time when cultivators can conveniently pay.

  • Canon of Economy:

Lastly, Adam Smith held that “every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible over and above what it brings into the public treasury of the State.” This means that the cost of collection should be as small as possible. If the bulk of the tax is spent on its collection, it will take much out of the people’s pockets but bring very little into the State’s pocket. It is not a wise tax.

Other Canons of Taxation:

Economic science has progressed much since the days of Adam Smith. Later writers have added to his canons.

The additions are:

(5) Canon of Productivity:

This canon emphasizes that a tax should bring in a substantial amount of money to the State. After all, the main object of the taxing authority is to secure funds. Therefore, a tax which does not yield a fair income is not of much use. It is much better to have a few taxes which yield good revenue instead of many taxes yielding a little.

(6) Canon of Elasticity:

This canon points out that a tax should automati­caly bring in more revenue as the country’s population or income increases. There should be an automatic link between the needs of the State and resources of the people. If, in an emergency, an increase in the rate of the tax brings in increased income, the tax is elastic.

(7) Canon of Simplicity:

It argues that the tax system should be simple; otherwise there would be confusion and, worse still, corruption. During the war and after, certain taxes, e.g., on sale of cloth and lather essential supplies in India resulted in corruption mainly because they lacked in simplicity.

(8) Canon of Variety:

It is also necessary that the tax system off a country should be diversified. Reliance on just a few taxes is risky. The revenue will not be sufficient, nor will it be fair, because it will not touch a large number of people. In order to be just, a tax system must be broad-based. In order to be adequate, it must be diversified, having a wide coverage over commodities and persons.

(9) Canon of Flexibility:

‘Flexibility’ in taxes is different from ‘elasticity’ mentioned earlier as a canon. Flexibility connotes the absence of rigidity in the tax system. A flexible tax quickly adjusts to the new conditions; on the other hand, elasticity means that income can be increased. Presence of flexibility is a pre-condition for elasticity. Lack of flexibility in a tax can cause financial troubles to a State.

=Written by Tehmeena=

Maximum and minimum prices

We have already discussed in previous topics that market systems may not allocate resources efficiently for many reasons. This is known as market failure. Governments intervene in order to correct such market failures. Imposition of price controls is one of such interventions.

Maximum Price

It is known as maximum price or price ceiling when the government sets a maximum legal limit of a price of a particular good or service. For this to have an effect on market, the price ceiling must be placed below the natural market price. This normally leads to a shortage – the quantity demanded will be greater than the quantity supplied.


If a government decides that the market clearing price of a good or service is too high and needs to be reduced, a price ceiling maybe imposed. The reasons for such an intervention could be:

  1. A monopoly which charges unreasonably high prices.
  2. The good or services is an essential or merit good.

Examples of maximum prices

  • Maximum prices for train tickets. With monopoly power, train companies could increase the price of tickets, but governments may impose a maximum price (or maximum price increase on firms) to keep tickets affordable – even if it leads to over-crowding.
  • Maximum price for rent. Governments have tried different types of rent control – keeping the cost of renting below a certain level.
  • Maximum price for food. In some developing economies, there are maximum prices for certain food items to keep them affordable.

Problems of imposing a price ceiling

  1. It often leads to shortage: unless the item is very much price inelastic, the quantity supplied will be far less than the quantity demanded. This could mean that some system of rationing needs to be in place. This will also result in long queues.
  2. Emergence of black market: This can happen in many ways. People could buy at the low maximum price and resell at a much higher price to those who were not able to buy it before the supply runs out. It can also be that the declared price and the price actually paid could be different, in which case the whole idea of maximum price is offset.
  3. The market will become less profitable. In the long-term this may lead to less investment and also decrease supply in the long-term. For example, rent controls may be a way to deal with the short-term problem of expensive housing. But, reducing rents will discourage many land owners from letting out property. It may also discourage people from building houses.

How to solve these problems?

A more long-term solution to the problem will be to use supply side policies rather than to distort the markets by controlling the price.

If housing is too expensive, a long-term solution is to build more affordable housing – and not just rely on maximum prices.

Maximum prices may be most useful in the case of a monopoly who is both restricting supply and inflating prices. An alternative maybe to reduce the power of monopolies; though in some industries, this is not possible – so maximum prices will be the most effective.

Minimum Prices

It is known as minimum price or price floor when the government sets a minimum legal limit of a price of a particular good or service. For this to have an effect on market, the price ceiling must be placed above the natural market price. This normally leads to a surplus – the quantity supplied will be greater than the quantity demanded.


Price floors are set by the government for certain commodities and services that it believes are being sold in an unfair market with too low of a price and thus their producers deserve some assistance.

Some situations in which price floors are used:

  • To attempt to raise incomes for producers of goods and services which are essential. e.g agricultural products — helped due to prices are subject to large fluctuations or due to large foreign competition.
  • To protect workers by setting minimum wage — ensuring workers earn enough to lead a reasonable existence.

The Disadvantage of Minimum Prices

  • Higher prices for consumers. We have to pay more for food.
  • Higher tariffs necessary on imports. For example – The EU put tariffs on food to keep prices artificially high.
  • May encourage oversupply and inefficient. The CAP(common agricultural policy in EU) encouraged farmers to produce food that no one actually wanted to eat.
  • Over-supply (butter mountains, wine lakes)


Government can eliminate the surplus by buying the excess supply at the minimum price. This will result in the shifting of demand curve to the right, thus creating a new equilibrium at a higher price level.

The Government may store it or sell it abroad. However, both these options have consequences. Buying the surplus and storing it will cost an opportunity cost for the government as they have to divert funds from other important areas and exporting it other countries may be considered as dumping especially if they are sold at below cost prices.


Government microeconomic intervention

This is the unit 3 of Cambridge A Level Economics Syllabus (Government microeconomic intervention)

AS Level topics:

Additional A Level topics:

  • Policies to achieve efficient resource allocation and correct market failure
  • Equity and policies towards income and wealth redistribution
  • Labour market forces and government intervention:
  • Government failure in microeconomic intervention

Law of diminishing marginal utility

Utility is the satisfaction one gets by consuming a good or a service. Marginal utility is the additional satisfaction one gets by consuming one extra unit of a good or service.

The law of diminishing marginal utility is a law of economics stating that as a person increases consumption of a good or service, while keeping consumption of other things constant, there is a decline in the marginal utility that person derives from consuming each additional unit of that good or service.

According to Marshall, “The additional benefit a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has”

The law of diminishing utility explains the downward sloping demand curve. The utility of additional units of goods increases as price falls, until price equals the marginal utility. This is the basis which demand curve is derived from.

As more and more quantity of a commodity is consumed, the intensity of desire decreases and also the utility derived from the additional unit.

Suppose a person eats Apples. the first apple gives him maximum satisfaction. When he eats the 2nd apple his total satisfaction would increase. But the utility added by the 2nd apple (the marginal utility) is less then the 1st apple. His Total utility and marginal utility can be put in the form of a following schedule.

Number of Apples eaten Total Utility Marginal Utility
1 50 50
2 75 25
3 87 12
4 93 6
5 96 3
6 93 -3

When he eats the 6th apple, his marginal utility is negative, which means it gives him a dis-utility.


diminishing marginal return

The law of diminishing utility explains the downward sloping demand curve. The utility of additional units of goods increases as price falls, until price equals the marginal utility. This is the basis which demand curve is derived from.

Equi-marginal principle

As we know, economics is the study of how we take our actions to satisfy our wants in the best way possible. Individuals are always concerned about maximizing their satisfaction. With the availability of certain amount of resources (money for example), a person chooses to buy a combination of different goods that will give him the maximum total utility. It is also the case that the marginal utility enjoyed from each unit of goods or services in that combination is equal at their optimum level. This is known as the equi-marginal principle.

This can be expressed by using the formula:

Marginal Utility of A

Price of A

= Marginal Utility of B

Price of B

Or using the formula:
MU1/MC1 = MU2/ MC2 = ………. = MUn/ MCn
Where MU1 = marginal utility from good one and MC1 is the marginal cost (price) of that good;
MU2 = marginal utility from good one and MC2 is the marginal cost (price) of that good.
The Equimarginal Principle
Marginal Utility of T-Shirts
Marginal Utility of Pizzas

When we look at this information, we can see that the marginal utility of both the goods equal at the 2nd T-Shirt and Third Pizza. Therefore, the particular person will buy 3 pizzas and 2 shirts.

Assumptions of Equi-marginal Principle

  • Utility could be calculated in cardinal numbers.
  • Consumer is rational. He desires maximum satisfaction from income.
  • The income of purchaser is steady.
  • The prices of products stay constant.
  • A good can be split up in small portion. It means that the purchaser can spend his income as he wishes.
  • The customer has understanding of the utility offered by different products.
  • Utility which a person receives from a product is determined by the quantity of that product only. It’s not at all influenced by the utility resulting from other items.
  • Consumption is made at a certain period of time. This implies that the budget period of the purchaser is constant.

Limitations of marginal utility theory

  • Difficulty of evaluating utility. Consumers often are not able to determine exactly how much utility will the consumption of a particular good will give. Especially if it is a new item, they won’t know it until after they have enjoyed the new product.
  • Consumers don’t have time to work out Marginal utility / price. Instead, they often purchase out of habit or gut feeling.
  • Consumers are not always rational. For example, we often see over-consumption of demerit goods. These goods actually give very low marginal benefit. Consumers may also be influenced by advertising and they often purchase on impulse.
  • Numerous goods. In the real world, consumers have fluctuating income, and innumerable goods to choose between. This makes even rough calculations difficult.
  • Many goods can’t be split up into small portions, e.g. cars.
  • Many goods are related – the utility of a DVD player, depends on the quality of DVDs and movies that come in those.

Consumer Surplus and Producer Surplus

Consumer Surplus

Consumer surplus is the value that the consumers gain from consuming a good or a service over and above the price paid for the good or service. It is the difference between the price that the consumers are willing to pay and the actual price being paid by them. Each individual may receive varying levels of consumer surplus. The total of the consumer surplus enjoyed by all the individuals can be summed up to get the total consumer surplus for the society. It can also be interpreted as the welfare that the society gains from consuming the good.

Marginal Social Benefit (MSB) is the additional benefit that the society benefits from consuming an extra unit of a good.


Consumer Surplus

In the above diagram, Consumer Surplus is shown by the shaded region which is above the price level and below the demand curve.

Changes to consumer surplus

  • If the price increases, it will decrease the consumer surplus and vice versa.
  • If the supply curve shifts to the left, the consumer surplus will decrease.
  • If the supply curve shifts to the right, the consumer surplus will increase.

Producer Surplus

Producer Surplus is the difference between the price received by the firms for a good or service and the price at which they would have been prepared to supply that good or service.

Another way of defining producer surplus is ‘as the surplus earned by the firm over and above the minimum that would have kept them in the market. It is the raison d’être of firms.

Producer Surplus

Producer Surplus

Changes to producer surplus

  • If the price increases, it will increase the producer surplus and vice versa.
  • If the demand curve shifts to the left, the producer surplus will decrease.
  • If the demand curve shifts to the right, the producer surplus will increase.


The workings/functions of the price mechanism

In a free market, the price of goods and services are determined by the forces of demand and supply. Which means the interactions of buyers and sellers determine the price of goods and services in a market.  Determining and changes in the price through price mechanism  can allocate resources. Resources move towards where they are in the shortest supply in comparison to demand, and away from where they are least demanded.

Price mechanism – The rationing function

Rationing means distributing the resource that is in shortage among those who are in need for it, even though each person may not get as much as he wants. In case of price mechanism, when a particular resource is in shortage, the excess demand over supply will drive up the prices, which will decrease the quantity demanded of that resource and the system has a rationing effect, as well as a conserving effect.


Price Mechanism – The Signalling function

Price changes send contrasting messages to consumers and producers about whether to enter or leave a market. Rising prices signals to consumers to reduce demand or withdraw from a market completely, and they give a signal to the existing producers to increase production or to potential producers to enter a market. On the other hand, falling prices signals to consumers to enter a market while sending a negative signal to producers to leave a market. For example, a rise in the market price of smartphones sends a signal to potential manufacturers to enter this market, and perhaps leave another one. Similarly, the provision of ‘free’ healthcare may signal to ‘consumers’ that they can pay a visit to their doctor for any minor ailment, while potential private healthcare providers will be discouraged from entering the market. In terms of the labour market, a rise in the wage rate provides a signal to the unemployed to join the labour market.

Price Mechanism – The Incentive function

An incentive is something that motivates a producer or consumer to follow a course of action or to change behaviour. Higher prices provide an incentive to existing producers to supply more because they provide the possibility or more revenue and increased profits. The incentive function of a price rise is associated with an extension of supply along the existing supply curve.

Social costs and benefits; cost-benefit analysis


Social Costs and benefits

Every business activity which takes place has some benefits and costs attached to it. The benefits go both to the owners of the firm as well as to external stakeholders. In the same way the owners and the external stakeholders have to pay a cost for the activities of the business.
Social cost:-

Social cost is the sum of private cost and external cost. For example, the manufacturing cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead costs of running the plant and labor costs) reflects the private cost for the manufacturer. Water or air is also polluted as part of the process of producing the car, This is an external cost borne by those who are affected by the pollution or who value unpolluted air or water. Because the manufacturer does not pay for this external cost, and does not include this cost in the price of the car. The air pollution from driving the car is also an externality produced by the car user in the process of using his good. The driver does not compensate for the environmental damage caused by using the car.

Social-Cost is the cost to an entire society resulting from an event, an activity or a change in policy. Social cost equals the sum of private cost and external cost.

When assessing the overall impact of its commercial actions in terms of social costs, a socially responsible business operator should take into account its own production expenses, as well as any indirect expenses or damages borne by others.

  • Private cost:-

It is the cost of setting up the business. The owner(s) pay for the hire of machinery, buying of materials, payments of wages. This is termed as Private Cost.

  • External Cost:-

The problems that the external stakeholders have to bear due to the firm’s activity are known as external cost. Example: cleaning a river which has been polluted by a firm’s waste products. Private firms usually ignore external cost.

Social benefits:-

Social benefits are the sum of private benefits and external benefits. For example, a college decides to slash its tuition rates by half. This encourages more people to get educated. A better-educated workforce, in turn, helps businesses produce more. Thus, even though the businesses did not pay for the reduced college tuition, they still reap a positive external benefit from the college’s move. The increase in the welfare of a society that is derived from a particular course of action. Some social benefits, such as greater social justice, cannot easily be quantified.

Social benefits is the sum of private benefits and external benefits

  • Private benefit:-

The benefit enjoyed by those involved in the production or consumption . For example, the revenue earned by the firm is a benefit for the owner and is termed as Private benefit.

  • External benefits:-

Some firms can cause external benefits. These are the benefits to the external stakeholders due to the activity of firm. For example, a firm may train workers, which might get them better wages in other firms. These external benefits are free.


Use of cost benefit analysis in decision making

Most of us are familiar with the term ‘cost-benefit analysis’ and have a basic grasp of it. It refers to how a project or decision might be evaluated, comparing its costs with its benefits. In many cases, it’s a like a quantified pros-and-cons list… It’s an analysis of the expected balance of benefits and costs… Cost-benefit analysis sometimes called ‘benefit–cost analysis’ is a systematic process for calculating and comparing benefits and costs of a project, decision, government policy… CBA has two purposes:

  1. Determine if it’s a sound investment/decision (justification/feasibility).
  2. Provide a basis for comparing investments, decisions, projects… It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs and by how much…

According to Nicole Gordon; cost-benefit analysis is used to decide if the cost of a solution and the economic benefits that would result from it are worth the risk. The main idea behind this strategy is that the benefits must exceed costs to justify the policy…

When performing a cost-benefit analysis, you make a comparative assessment of all the benefits you anticipate from your project and all the costs to introduce the project, perform it, and support the changes resulting from it. Cost-benefit analyses help you to:

  • Decide whether to undertake a project or decide which of several projects to undertake.
  • Frame appropriate project objectives.
  • Develop appropriate before and after measures of project success.
  • Prepare estimates of the resources required to perform the project work.
  • Everything gets a dollar value in a cost-benefit analysis.

There are some advantages and disadvantages of cost and benefit analysis.


  • The main advantage of cost benefit analysis is its simplicity. You are simply looking at whether benefits outweigh costs. When you do this quantitatively, measuring the dollar amount of the benefits and the costs involved in a project, the cost benefit is very easy to see.


  • The simplicity of cost benefit analysis can paradoxically lead to complications; to gain this simplicity, you have to use a common measurement– one of the disadvantages of CBA. Determining the quantitative benefits of a project is relatively straightforward; you basically add up the costs and benefits and compare the two. However, when you factor in qualitative benefits, the picture can become more complicated.


You are considering implementing an employee bonus program, you will obviously incur costs. In exchange, you may receive benefits like increased employee satisfaction, decreased turnover and greater productivity. The benefits are significant but difficult to compare– apples to apples– to the costs involved… A frequently made mistake is the use of non-discounted amounts for calculating the costs and benefits; typically the cost is tangible– hard and financial– while the benefits are hard and tangible, but also soft and intangible.

Written by Tehmina Khan

Externalities and Market Failure

Reasons for market failure

Market Failure occurs when there is an inefficient allocation of resources in a free market. This may occur due to:

Types of market failure:

  1. Positive externalities – Goods / services which give benefit to a third party, e.g. a bee keeper’s bees can pollinate nearby crop fields. Even though this is a good thing, the market system fails to account for the benefit arising from it.
  2. Negative externalities – Goods / services which impose cost on a third party, e.g. smoking causes cancer to those who don’t smoke as well (through passive smoking).
  3. Merit goods – People underestimate the benefit of a particular good, e.g. education. Therefore they under-consume it. Without the government encouragement, the people under-consume such goods.
  4. Demerit goods – People underestimate the costs of good, e.g. smoking. Even with so much campaigns against smoking, people still continue to smoke.
  5. Markets fail to provide public Goods – Goods which are non-rival and non-excludable – e.g. police, national defense. The market simply fails to provide them.
  6. Monopoly Power – when a single firm controls the market they can set higher prices and exploit the consumers.
  7. Inequality – unfair distribution of resources in free market
  8. Factor Immobility – E.g. geographical / occupational immobility
  9. Imperfect and asymmetrical information – where there is no enough information to make an informed choice.


A consequence of an economic activity that is experienced by unrelated third party. An externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit.

Types of externalities:-

There are two types of externality.

  • Positive externality
  • Negative externality

Positive externality:-

A positive externality is a benefit that is enjoyed by a third party as a result of an economic transaction. Third parties include any individual, organization, property owner, or resource that is directly affected. While individuals who benefit from positive externality without paying are called to be free rider. Government can play a role in encouraging positive externalities by providing subsidies for gods or services that generates spillover benefits. Such subsidies provide an incentive for firms to increase the production of goods that provide positive externalities. And, because the spillover benefits goes to society, government subsidies are a way for society to share in the cost of generating positive externalities.


  • When you complete high school, you’ll reap the benefits of your education in the form of better job opportunities, higher productivity, and higher income. A technical degree or college education will further enhance those benefits. Although you might think you are the only one who benefits from your education, that isn’t the case. The many benefits of your education spill over to society in general. In other words, you can generate positive externalities. For example, a well-educated society is more likely to make good decisions when electing leaders. Also, regions with a more-educated population tend to have lower crime rates. In addition, more education leads to higher worker productivity and higher living standards for society in general.
  • Social benefits from the maintenance of a post- officenetwork.
  • A new motorway or road improvement scheme generates third party benefits including reduced transport cost for local firms and generates a regional multiplier effect.


Negative externality:-

A negative externality occurs when an individual or firm making a decision does not have to pay the full cost of the decision. If a good has a negative externality, then the cost to society is greater than the cost consumer is paying for it. Since consumers make a decision based on where their marginal cost equals their marginal benefit, and since they don’t take into account the cost of the negative externality, negative externalities result in market individual inefficiencies unless proper action is taken. Negative externality is a cost that is suffered by third party.third parties include any, organization, property owner, or resource that is indirectly affected.

Examples of negative externalities:-

  • A common example of a negative externality is pollution. For example, a steel producing firm might pump pollutants into the air. While the firm has to pay for electricity, materials, etc., the individuals living around the factory will pay for the pollution since it will cause them to have higher medical expenses, poorer quality of life, reduced aestetic appeal of the air, etc. Thus the production of steel by the firm has a negative cost to the people surrounding the factory–a cost that the steel firm doesn’t have to pay.
  • If you play loud music at night your neighbour may not be able to sleep.
  • If you produce chemicals and cause pollution as a side effect, then local fishermen will not be able to catch fish. This loss of income will be the negative externality.
  • If you drive a car, it creates air pollution and contributes to congestion. These are both external costs imposed on other people who live in the city.
  • If you build a new road, the external cost is the loss of a beautiful landscape which people can no longer enjoy.



Tehmina Khan contributed to this tutorial