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Explain the difference between a Subsidy (for consumption) and a Tax (on consumption), discussing when a...

Explain the difference between a Subsidy (for consumption) and a Tax (on consumption), discussing when a government may want to use one of these tools in a particular market.

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Answer #1

Government imposes tax or subsid when there is an externality in consumption. In unregulated free market equilibrium, price charged is lower (higher) than, and quantity bought & sold is higher (lower) than the socially efficient price and quantity when the negative (positive) externality is internalized.

When there is a negative externality in consumption, imposition of a (Pigouvian) tax will increase the price and decrease the quantity to the socially optimal level, and when there is a positive externality in consumption, imposition of a (Pigouvian) subsidy will decrease the price and increase the quantity to the socially optimal level. Therefore, deadweight loss from the externality is eliminated.

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