Explain why training might be underprovided in a free market economy. Explain and illustrate the effect of a subsidy equal to the marginal external benefit being given to the training providers. This is Q3B.36. I am not able to understand the answer given in Course notes. Can anyone please explain.
In a free market, the level of training provided will be where demand (which reflects the marginal private benefit (MB) to the firms buying the training) is equal to supply (which in a perfectly competitive market, will equal the marginal private cost (MC) of the firms supplying the training), ie at Q1. However, this will be below the social optimum, where social welfare is maximised, which occurs where the marginal social benefit (MSB) is equal to the marginal social cost (MSC) of training, ie at Q2. This is due to the external benefit of training to society, which means that the MSB is greater than the MB. In order to correct for this, the government can provide a subsidy to suppliers equal to the value of the marginal external benefit at Q2. This has the effect of reducing the MC of suppliers by the amount of the subsidy, ie shifting the supply = MC curve vertically downwards by the amount of the subsidy, so that it now cuts the demand = MB curve at Q2. Hence, the social optimum of Q2 is obtained.
