Discuss the proposed government subsidy to prevent Thomas Cook from reaching its shut-down point

Edexcel A-Level Economics Paper 1 June 2021 Extract

With reference to Extract C, discuss the proposed government subsidy to prevent Thomas Cook from reaching its shut-down point. (12 marks)

One reason in favour of the proposed subsidy is that it could have prevented Thomas Cook from shutting down in the long-run. Thomas Cook's management said they ‘had no choice’ and ‘ceased trading’ in 2019. The long-run shutdown condition is when average revenue is less than average costs (AR<ATC). In economics, average costs are total costs divided by output. Total costs are the sum of total fixed costs and total variable costs but importantly they also include the opportunity cost of running the business. This explains why a business owner would shut down a business if a business is not at least as profitable as their next best alternative. The business owner would be better off investing their time in another business or job.

Another reason in favour of the potential subsidy is that it could have been useful in preventing Thomas Cook from shutting down in the short-run. In the short-run, there is at least one fixed factor of production, such as land. Firms stop producing goods and services in the short-run when average revenue is less than average variable costs. A susbidy is a payment made from the government to firms to cover some of their costs of production. If the subsidy goes towards each unit of output, this can reduce the firm's average variable costs. The merger with MyTravel was meant to create tis £75 million-a-year saving, but this didn't happen. If the subsidy helps reduce variable costs below their average revenue, the firm can both cover their variable costs and be able to pay off their fixed costs over time.

However, the major downside of the government subsidy is the potential 'moral hazard' as mentioned in extract c line 29. Moral hazard would exist as this subsidy could incentivise Thomas Cook and similar firms to take more risks because in the end they do not bear the full cost of the risks. In this case the government would have paid £150 million despite Thomas Cook making the mistake of a failed merger. This ends up costing the taxpayer more money, and there would also be an opportunity cost, as the government would have had to cut spending in other areas. This explains why the government refused to subsidise Thomas Cook at the time.

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