First 693 words of the document:
Discuss the extent to which a subsidy given to producers might encourage an increase in the
consumption of a product such as pu'er tea which generate positive externalities.
A subsidy is "money paid, usually by government, to keep prices below what they would be in a free
market, or to keep alive businesses that would otherwise go bust, or to make activities happen that
otherwise would not take place. Subsidies can be a form of protection by making domestic goods and
services artificially competitive against imports. By distorting markets, they can impose large economic
costs." At the bottom of the case, it says that the government was trying to encourage farmers to destroy
remaining pu'er tea plantations, as the sudden drop in the demand for the tea has caused an excess supply
and market failure. Market failure is when resources aren't allocated effectively or efficiently and
governments intervene with things such as subsidies and indirect taxation in attempts to correct it. In this
case, factors of production need to be diverted back to corn and rice in order to correct the market failure.
The market failure occurred because of many reasons. One of which was that an increasing number of
farmers were supplying at a much faster rate than what was demanded. This inevitably lead to market
failure. However the mean reason for this was external: consumers were lead to believe that the tea
possessed powers of "weight loss" and "a cure to hangovers." So it could be argued the production of
pu'er tea and the consumption of it results in positive externalities. Because these were only claims that
were not backed up by evidence, when consumers realised they were not actually have any effect on them,
they stopped demanding pu'er tea.
A subsidy for a business increases supply and lowers costs. The farmers need this incentive to increase the
production of things that got forgotten in the pu'er tea surge; staple foods. Farmers already have an excess
supply of pu'er tea that is ready to distribute if there was another surge in demand. But the neglected
produce isn't getting produced despite its demand being more consistant. The effect a subsidy would have
on the corn and wheat market would mean the produce could be sold for a fair price. Also, in China
especially, staple foods are a necessity and market failure has also occurred to due to their lack of
It's been proven that there are no scientific benefits from pu'er tea but there are several from staple foods.
And this is why farmer should shift production from pu'er tea to staple foods. Obviously this creates pareto
efficiency but should correct the market failure. This is shown in the graph below. Currently, farmers are
operating at point A, but with government intervention they could shift production to point B and begin to
correct the market failure. Ideally, they want to reach point C and shift the entire production curve outwards
in a growth of the economy. What they don't want to do is reach point D, where their economy has
reduced, possibly due to market failure.
The government could influence this shift in production with a subsidy, which they are more than justified to
do. However the effectiveness of this intervention depends alot on the exact amount of subsidy paid out to
farmers with respect to the external benifits: if the government doesn't pay enough, it will be likely that
farmers will be unable to attract demand from low prices and therefore may be unable to afford excess
labour costs in order to produce enough crops. This might not be a problem in China however where manual
labour is cheap. Another route the government could take is to subsidise the production of pu'er tea in
order not to worsen the problem.