Subsidies

A subsidy is a payment made by a government to an organisation [usually a private firm] to reduce production costs, increase production, and reduce price.

At total subsidy refers to the total amount given to a firm over a period of time, whereas a unit subsidy refers to the payment per unit of output produced.

Which goods get subsidies?

Given that the aim of a subsidy is to increase production beyond the free market level, and hence reduce price, subsidies might be granted on any good or service which is deemed beneficial, but is currently under-produced and under-consumed. Goods and services where subsidies are common include:

Merit goods, such as healthcare provision.

  1. Agricultural products - which are strategic goods, and where government might wish to protect farmers and growers to help achieve 'food security'.
  2. Pure and quasi-public goods, such a public highways and bridges.
  3. Transport services needing subsidies to keep unprofitable routes running, such as local bus companies.
  4. Firms producing new technology goods or services which have growth potential, and which have strategic importance - such as research in AI.
  5. Goods which are going for export - in order to improve the balance of trade - export subsidies reduce export prices. For example, in 2019 India subsidised its sugar exports to the tune of $475bn1.
  6. House-building - housing shortages can significantly impact on other aspects of an economy, such as labour mobility. Various schemes exist, including the subsidised building of social homes in Denmark2.
  7. Home insulation, or other housing expenditure - which can be justified on the ground of reducing global warming.

The effects of a subsidy

The effect of a subsidy is to reduce production costs, and reduce prices to consumers - as shown in the simple example below:

subsidy schedule

The effect of the subsidy of £200 per unit produced is to reduce price from £400 to £300, with equilibrium output rising from 5 to 6 units.

This can be shown graphically:

subsidy graph

The subsidy shifts the supply curve vertically downwards by the amount of the subsidy, which in this can is £200. Given that the subsidy per unit is the same no matter how many units are produced, the new supply curve (S1) will be parallel to the original (S). Price will fall to create a new equilibrium, and output will increase.

The effect of price elasticity of demand

The effect of any subsidy will depend upon the price elasticity of demand. If price elasticity of demand is more inelastic (with a steeper gradient for the demand curve) then the effect on price and output is smaller. The effect of the subsidy is larger when consumer's are more responsive to the price reduction (and hence a flatter gradient.) This is significant because variations in price elasticity of demand will have a bearing on how successful a subsidy is in terms of increasing consumption.

subsidywith inelastic price elasticity of demand

For example, if the aim of a subsidy on university tuition fees is to increase the level of education of the population (and hence labour productivity), then the subsidy should encourage more individuals to attend university. However, if potential students do not respond, then the scheme has been unsuccessful, with a high opportunity cost.

The incidence of a subsidy

The incidence of a subsidy shows how the benefit of the subsidy is distributed between consumers and producers. We can distinguish the economic incidence of a subsidy, which shows who the subsidy actually benefits, and the legal incidence, which refers to who the subsidy is intended to benefit. These may or may not be the same. For example, a subsidy on student tuition fees which is intended to reduce tuition fees to students by, say £3000 per year (the legal incidence) might actually reduce fees by only £2000 (the economic incidence), with universities retaining more of the subsidy and passing on less of it to students.

In the diagram, the subsidy per unit is bd, and the new quantity consumed is Q1. As a result, price falls to P1 - which is less than the subsidy. The benefit to consumers is the price reduction, c - d, (P to P1) with the total gain (incidence) represented by the area P, c, d, P1. The gain to the producer  is b - c  per unit and the whole gain to the consumer is the area a, b, c, P. The total amount of the subsidy paid by the government is the sum of both areas, or a, b, d, P1.

subsidy incidence

Taxation

What are the effects of taxation?

Taxation
PED

What determines price elasticity?

PED
Education

Why is education regarded as a merit good?

Merit goods


1. Reuters - https://www.reuters.com/article/india-sugar-exports-idINKBN28Q178

2. Tunström, M, 2020, Building Affordable Homes, Nordregio Report, viwed April 10th, 2021, https://norden.diva-portal.org/smash/get/diva2:1420468/FULLTEXT01.pdf