Subsidies (Cambridge International A-Level Economics)

Subsidies

• A subsidy is a payment made by the government to producers to reduce the cost of production
• Governments frequently use subsidies to encourage production or consumption of merit goods such as energy-efficient products, electric vehicles, healthcare, and education

How a subsidy reduces the welfare loss (or generates a welfare gain)

Diagram analysis

• The free-market equilibrium is at P_eQ_e - where MPB = MSC

  • Market failure exists as MSB > MSC at the free market equilibrium, meaning the good is under-consumed
  • Optimum level of output is at Q_opt

• A subsidy shifts the supply curve right from S → S₁

  • It does not completely eradicate the potential welfare gain but moves the market closer to the optimum level of output (Q_opt)

  • The potential welfare gain has been reduced as shown in the diagram

    • This represents a reduction in deadweight loss and an improvement in allocative efficiency

• The new market equilibrium is at P₁Q₁

  • This is a lower price and higher output
  • There is less under-consumption and so less market failure
  • Some of the external benefits available have been realised

Subsidy incidence

• The incidence (share) of the subsidy is determined by the PED of the product

  • If governments subsidise goods or services with high PED, the increase in QD will be more than proportional to the decrease in price
  • Producers keep some of the subsidy and pass the rest on to the consumers

A diagram which demonstrates the cost of a subsidy to the government (A+B) and the incidence received by the consumer (A) and producer (B)

Diagram analysis

• The original equilibrium is at P₁Q₁

• The subsidy shifts the supply curve from S → S + subsidy:

  • This increases the QD in the market from Q₁→Q₂
  • The new market equilibrium is P₂Q₂
  • This is a lower price and higher QD in the market

• Producers receive P₂ from the consumer PLUS the subsidy per unit from the government

  • Producer revenue is therefore P₃x Q₂
  • Producer incidence of the subsidy is marked B in the diagram

• The subsidy decreases the price that consumers pay from P₁ → P₂

  • Consumer incidence of the subsidy is marked A in the diagram

• The total cost to the government of the subsidy is (P₃ - P₂) x Q₂ represented by area A+B

  • This creates an opportunity cost, as government funds could be used for alternative purposes

Exam Hint When dealing with a subsidy, the producer benefit is now the top portion of the incidence area, and consumer incidence is below

The effectiveness of subsidies

• Estimating the appropriate size of a subsidy can be difficult

• Many subsidies are applied uniformly, meaning they are not linked to consumers’ income levels or ability to pay. Unlike income-based taxes or benefits, subsidies usually reduce the price by the same amount for all users

• As a result, both higher-income and lower-income consumers benefit equally per unit consumed, even though the policy may be intended to support those on lower incomes

  • This makes it important to consider who actually gains from a subsidy

Examples

1. Domestic energy subsidies

• In some countries, governments subsidise electricity or gas to keep household energy bills affordable
• While this can help low-income households cope with rising living costs, wealthier households also benefit, often to a greater extent because they consume more energy
• In addition, lower prices may increase demand, leading to supply pressures or higher government spending.
• If subsidies are paid directly to energy suppliers, there is no guarantee that firms will become more efficient or invest in cleaner technologies

2. Subsidies for education and training

• Governments often subsidise further education or vocational training to improve workforce skills and productivity
• These subsidies can increase access to education and benefit society through higher employment and economic growth
• However, some of the financial benefits may go to individuals who could afford training without support, raising questions about whether the subsidy is well targeted

Exam Hint A great evaluation point is that:

There is no guarantee that subsidies will fully correct market failure, as firms may not pass on the full benefit to consumers

Taxes vs Subsidies (Comparison)

• Taxes discourage consumption and production, while subsidies encourage them