📉 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 1 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 2