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Technically speaking, a free market economy is free of subsidies by definition. A subsidy introduced to a previously free market transforms it into a mixed economy. Economists who promote a mixed economy often argue that subsidies are justifiable to correct market failures or to provide the "socially optimal" level of goods and services. Free market economists counter by suggesting that subsidies prevent efficient market outcomes and corrupt the political process.

Arguments for Justifiable Subsidies

In contemporary neoclassical economic models, there are circumstances where the actual supply of a good or service falls below the theoretical equilibrium level. This unwanted shortage creates what economists call a "market failure." One form of correcting this imbalance is to subsidize the good or service being undersupplied. The subsidy lowers the cost for the producers to bring the good or service to market. If the right level of subsidization is provided, all other things being equal, the market failure should be corrected.

There are many goods or services that allegedly provide what economists call "positive externalities." A positive externality is achieved whenever a transaction between two parties provides an indirect benefit to a third party. Many subsidies are implemented to promote positive externalities that might not otherwise be provided at the socially optimal threshold.

Arguments Against Government Subsidies

Free market economists are wary of subsidies for a variety of reasons. Some argue that subsidies unnecessarily distort markets and divert resources from more productive uses to less productive uses. Similar concerns come from those who suggest economic calculation is too inexact and microeconomic models are too unrealistic to ever correctly calculate the impact of market failure. Others suggest that government spending is never as effective as government projections claim.

To the extent subsidies raise the profits of those receiving beneficial treatment, a new political incentive is created to lobby for the subsidy even after its usefulness runs out. This potentially allows political interests and business interests to create a mutual benefit at the expense of other taxpayers or competitive firms.

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