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3.2.2 Impact and incidence of
subsidies
Def: payments of money from the government to producers to
lower costs of production and prices.
Basic Analysis
Production Subsidy (bd)
‘decreases’ total costs of supply for
firms.
Supply shifts to the right (S to
S+subsidy).
Consumer price falls (P1 to P2).
Demand extends (a to b).
Producer price rises (P1 to P3)
Supply extends (a to d)
Equilibrium quantity rises (Q1 to
Q2).
New equilibrium occurs at point b.
Incidence of Subsidy
Subsidy: PED and PES
PED more elastic than PES: Large rise
in Qd, subsidy mainly goes to producer.
3.2.2 Impact and incidence of subsidies
PED more inelastic than PES: Small
rise in Qd, subsidy mainly goes to
consumer
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Pros & Cons
Lower prices: controls inflation
Merit goods: more supply, lower
prices, more demand.
Market based approach: uses the
price mechanism (S&D).
Protects declining industries
Costly: higher taxes / increased
borrowing.
Opportunity cost: less spending
on other areas.
Welfare loss: some producers
receive the subsidy but don’t need
it.
Reliance: firms might rely on the
subsidy and become inefficient.
Shortages: demand might rise
faster than supply
Evaluation ~ Subsidies are more effective when:
Benefits > costs.
There is a small opportunity cost.
Size of subsidy is correctly calculated.
Given to firms that need it.
Demand is price elastic.
Welfare loss is minimised.
3.2.2 Impact and incidence of subsidies
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