1.9 Government intervention - Subsidy

subsidy definition

money paid by the government to producers to encourage consumption and production of a goods and services

Subsidy example

farmers to produce food, energy firms to produce renewable energy, and pharmaceutical businesses to produce new healthcare drugs.

(increases well-being)

reasons for subsidies

Government use subsidies to support producers and consumers in different markets

reason to support consumers though subsidies

Some goods and services carry significant social benefits, and their consumption increases welfare

• positive externalities and merit goods are often supported by subsidies

why are subsidies given to producers? - reasons

• support strategically important industries (agriculture/farming)

• by subsidising producers the government protects supply in these important markets

• job creation

• encourage investment t and boost long-term growth

• help domestic firms compete against foreign imports

importance of elasticity in reaction to subsidy

Elastic supply is effected positively by a subsidy.

→ increase output easily, quickly respond plus the subsidy will lower costs of production increasing quantity supplied a lot

Elastic demand

→ consumers are sensitive to price changes, but subsidy lowers prices, makes them want to buy more. = large increase in quantity demanded than is to elastic demand and subsidy

why is PED important when governments impose indirect taxes?

Because PED affects:

• who bears more of the tax burden (consumer or producers)

• how much quantity demanded falls

• how much revenue the government collects

• the size of the welfare loss (deadweight loss)

=> if demand is inelastic, consumers still buy the good = higher tax revenue = lower welfare loss (consumer surplus>producer surplus)

=> if demand is elastic, quantity drops a lot = lower tax revenue = higher welfare loss (producer surplus>consumer surplus)

If demand is inelastic who gains more surplus?

consumers gain more surplus

• Qd does not change much but price falls significantly with subsidies or rises significantly with taxes.

If demand is elastic who gains more surplus?

producers gain more surplus

• the price does not fall as much as it would if demand was price inelastic

• welfare loss triangle is bigger when supply is inelastic because more inefficient producers are drawn into the market

PES effect of Subsidy

If the PES of a good is more elastic than demand = consumers gain more surplus than producers.

PES>PED supply is more responsive to changes than demand. Producers can easily increase QS if prices change and consumers are less responsive.

SUBSIDY - lowers the market price paid by consumers and raises the effective price producers receive. Supply curve shifts downward (because producers get paid the price plus subsidy)

If PES is less than PED = producers gain more than consumers.

Impact on stakeholders

1. Consumers

Subsidies lead to a fall in prices in a market, which benefits consumers because they experience a rise in consumer surplus.

2. Producers

(+) lower production cost = increased supply = higher profits. Greatest benefits to those that cannot survive without subsidy

(-) potential dependency and inefficiency - overproduction, misallocation of resources.

3. Government

(+) help stabilise the market (increase output)

(-) GOVERNMNT FACES SUBSIDY TRADE-OFFS:

opportunity cost, budgetary cost (can strain public budget, because subsidies require funding often from tax revenue), increase pressure on tax system

→ distorted market - subsidies can alter market signals by artificially lowering prices or encouraging overproduction = inefficient allocation of resources. Causes market to become less competitive and efficient

4. Welfare

Inefficient allocation of resources - could have been used elsewhere in more productive areas (opportunity cost)

(-) subsidies can lead to welfare loss when they draw producers and resources into markets that wouldn’t exist without support.

Less efficient = welfare loss

(+) promote social equity and economic stability (low-income support - basic goods, reduce poverty)

Due to lower prices

Short term effects of producers being drawn into market via subsidies

• lower production costs → more producers enter the market

• Increased output → lower prices for consumers

• Potential boost to consumer and producer surplus

Long term effects of producers being drawn into market via subsidies

• some producers are inefficient and only survive because of subsidies

• Mis allocation of resources → resources tied up in less productive uses

• Reduced competition and market efficiency

• Potential welfare loss as resources could be better used elsewhere