2. Subsidy

What is a subsidy?

A sum of money granted by the government to a business to encourage the production of merit goods. Firms can then reduce prices, increasing demand.

Draw a subsidy diagram.

State the benefits of subsidies.

1. Reduce prices and increase quantity.

2. Leads to an increase in production/ consumption of merit goods.

3. Encourages firms to take part in activities that are beneficial.

4. They encourage firms to develop more products with positive externalities.

State the drawbacks of subsidies.

1. Money to pay for subsidies will have to be met through taxation.

2. All subsidies have an opportunity cost.

3. It's difficult to estimate the extent of the positive externality and work out how much subsidy to grant.

4. Government may have poor information about the product/ service and not know how much to subsidise.

5. There is a danger that government subsidies encourage firms to be inefficient and rely on subsidies instead of improving efficiency.