Effects of Subsidies

Impacts of Subsidies

The general impact of subsidies is that they make it easy for firms to produce certain goods. After all, they're being assisted with free cash or tax pardons. These tax pardons or cash payments reduce the production expenses producers have to bear. In the end, consumers will be paying less for the subsidized product. From this, we can tell that there are two general impacts of subsidies:

1. The first impact of subsidies is the reduction in both production costs and the price of the commodity, making consumers buy more of that product.

2. The second impact of subsidies is that more firms will enter the market for subsidized products since it is now affordable for them to produce!

Here is an example.

Effects of Subsidies on Consumer Surplus

The effect of subsidies on consumer surplus is that it increases it. This is because the consumer surplus represents the difference between what consumers are willing to pay and what they actually pay for the commodity. This is derived from the subjective value we attribute to purchasing things.

Why do subsidies cause the consumer surplus to increase? Let's explain this with an example!

The above example shows the effect of subsidies on the consumer surplus in a very simplified form! Figure 1 highlights the consumer surplus on the subsidy effect model.

Figure 1. Consumer surplus on the subsidy effect model, StudySmarter Originals

As shown in Figure 1, the initial price consumers had to pay was P₁. Since P₁ is the price consumers were willing to pay in the first place, there is only consumer surplus (CS) for those willing to pay more than P₁. However, the subsidy helps reduce the price (from P₁ to P₂). This results in a consumer surplus covered by the area above the supply curve between P₁ and P₂.

Effects of Subsidies on Producer Surplus

The effect of subsidies on the producer surplus is that it increases it! The producer surplus is the difference between what producers are willing to supply goods for and what they actually receive for supplying the goods. This occurs for producers as their marginal cost rises with each additional unit, so the early units produced are cheaper than the end selling price.

Let's explain how subsidies cause the producer surplus to increase using an example!

The above example shows the effect of subsidies on the producer surplus in a very simplified form! Look at Figure 2 as it highlights the producer surplus. Now, let's go into some detail. Read on!

Figure 2. Producer surplus on the subsidy effect model, StudySmarter Originals

Looking at Figure 2, the initial price consumers were willing to pay was P₁. This only provided some producer surplus (PS). However, the subsidy helps increase the price producers receive (from P₁ to P₃). This results in a producer surplus covered by the area between P₁ and P₃.

Effects of Subsidies on the Economy

Subsidies are used to support critical industries, fund research, and maintain minimum standards of living. Subsidies also affect the determinants of supply, often for the better in the short run, however, they can have consequences for some.

The most common subsidies are in food production, which most countries in the world use some form of. This helps a nation keep its food production industry healthy to keep the population satiated.

However, these subsidies in food production can hurt international trade, many have complained that Chinese farmers are out-competing others due to unfair subsidy advantages.¹

The effect a subsidy has on the market depends on the elasticity of supply and demand within the target market.

This can vary greatly, demand for food is usually inelastic as humans need to eat the same amount of food whether they're rich or poor. In this case, subsidizing food can save consumers money, but they typically aren't buying more even with the artificially low price.

Taxes are used to fund subsidies that provide research grants which lead to advances in technology. Firms are then able to buy this technology sooner, as researchers can leverage more risk and the technological advancement will cost less since the research was publicly funded.

This can be seen in the deep dive above, as Elon Musk has used government subsidies to build profitable and effective technological advancements and products. However, governments must collect taxes to be able to give out the support money that helped build his empire.

Effect of Subsidy on Supply and Demand Graph

Below is a graphical representation of how a subsidy affects a market at equilibrium.

The subsidy splits the benefit, where suppliers get a higher price, at the same time as consumers receive a lower price. How is this possible, read the example below for specific details.

Deadweight Loss occurs in the market as a result of providing the goods beyond the equilibrium quantity. Of the total tax dollars required for this subsidy most of the cash creates a surplus, however, because the value of transactions after equilibrium is diminished by marginal returns, not all of the subsidy's value is realized.

Figure 3. Subsidy Effect Model, StudySmarter Original

While using the graph provided in figure 3, Consider the market of Brussel Sprouts:

Try your best to imagine an evil government that hates happiness and wants your parents to make you eat brussel sprouts, so they put a $2 subsidy on Brussel sprouts. This means that the government tells producers to sell to consumers for $2 and the government will give $2 for each unit sold.

In the example above, the government pays $2000 to subsidize brussel sprouts. Consumer and producer surplus both increase $875 more than their previous surplus. The total surplus created by the subsidy is $1750, which means that $250 of value is not realized and becomes a deadweight loss.

This $250 DWL is a result of customers who don't value the good enough to buy it normally. Similarly, producers can increase the quantity, but at a high cost, so it incentivizes inefficient production for higher quantity. However, it's important to weigh the $250 DWL against the $1750 gain in the total market.

Government intervention in the market through subsidies does create a benefit but it is not a 100% return on investment. Due to the nature of diminishing utility, the additional sales created by the subsidies don't generate as much value as the tax dollar injected.

It's important to consider what alternatives the tax dollars used for subsidies can create. Fiscally conservative individuals would say that they should decide where to spend their money, rather than the government. This actually would eliminate the deadweight loss, as consumers can buy things that maximize their utility.

When governments collect taxes it lowers consumers' ability to maximize personal utility, and the government expenditures are not as efficient as in a competitive market. Overall, government intervention done to efficient markets can only hurt the market.

Examples of Subsidies

Examples of subsidies in the US are subsidies on agricultural produce, healthcare, and housing among other subsidized products. Let's describe some examples below.

First, let's look at a producer surplus.

Now, let's look at a consumer surplus.

That's it! You reached the end of the article! You should read our article on Taxes and Subsidies to improve your understanding of the topic.