Subsidies

A subsidy is an amount of money given directly to firms by the government to encourage

production and consumption. A unit subsidy is a specific sum per unit produced which is given
to the producer.

The effect of a specific per unit subsidy is to shift the supply curve vertically downwards by the
amount of the subsidy. In this case the new supply curve will be parallel to the original.
Depending on elasticity of demand, the effect is to reduce price and increase output.

The incidence of a subsidy

The economic incidence of a subsidy indicates who is made better off by the subsidy. In contrast,
the legal incidence indicates who, by law, the subsidy is intended to help. In the diagram below,
the subsidy per unit is A – B, and the new quantity consumed is Q1.
However, the price the consumer pays does not fall by the full amount of the subsidy – instead it
falls from P to P1. Hence, although the intention of the subsidy may be to reduce the price to the
consumer by the full amount of the subsidy, the producer gets some of the benefit in terms of
extra revenue that they can keep. The gain to the consumer is P - P1 per unit, and the whole gain
to the consumer is the area PFBP1.

The gain to the producer is C – P per unit and the total gain to the producer is CAFP. The overall
cost of the subsidy to the government is the area, CABP1.
 The Effects of Subsidies on the Supply & Demand Curve
by Cynthia Gaffney; Reviewed by Michelle Seidel, B.Sc., LL.B., MBA; Updated April 02, 2019

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Governments in many counties offer assistance in the form of financial subsidies to various companies and
individuals with the goal of improving the cost and availability of goods and services for society. Economists
chart the effects of these subsidies to understand how they influence the position of the supply and demand
curves in specific ways.

An Overview of Subsidies

A subsidy is a certain amount of money, usually given by a government entity, to help a business or an
industry keep prices for its goods or services competitive or low enough to remain affordable.

These subsidies can come in the form of prices that are kept artificially high, such as subsidies aimed at
increasing the income of farmers. The government may provide services, such as subway rides or college
education at a price that is below cost. It may subsidize new products or technologies by providing tax relief in
the form of grant money, or pay a portion of the interest on loans used to finance construction of necessary
roads or power plants.

What Are the Supply and Demand Curves?

Economists study the relationship between the supply of goods and services in the economy and the demand
for those goods and services. The quantity that producers want to supply at various prices is related to the
number of units that consumers want to buy at different price points.

When buyers and sellers or producers agree on the unit price for a given item or service, economists call this
the equilibrium price. In equilibrium, the quantity of goods supplied by producers is exactly equal to the
quantity of goods demanded by consumers.

The curves of supply and demand represent different price-quantity combinations. Each combination is plotted
on a chart, and the line drawn from one point to the next creates a curve. The price of a good is shown on the
chart's vertical axis and quantity on the horizontal axis. For a chart plotting a demand curve, for example, you
would typically see data showing that as prices drop, consumers demand more of a given good or service.

When factors other than price affect the demand for an item, the curve changes in a different manner. While
price-quantity changes can be traced along the plotted curve, non-price changes will cause the curve to shift
position, depending on the type of change.

How Subsidies Affect Supply and Demand Curves

Governments attempt to influence the economy by using both supply- and demand-side subsidies. The effect
of these subsidies is then studied by charting the results on supply and demand graphs or charts over time and
analyzing the changes.

If the supply of a good is inelastic, or doesn't change in response to a change in prices, this would mean that a
subsidy program has no effect, and would become nothing more than a handout to the suppliers. If a supplier,
such as a home builder couldn't increase its production any further, the supply curve would rise up steeply, and
economists would call this an inelastic response to an increase in price.

Demand-Side Subsidies

A subsidy that affects the demand side would actually shift the entire curve from one position to another, such
as moving to the right or left. This differs from the curve staying in one spot but new data points causing it to
steepen, for example. A certain supply-price equilibrium exists on the chart, but this equilibrium would shift in
the presence of a subsidy.

In the case of a demand-side subsidy, this would entail an increase in price rather than an increase in the
number of available homes. This subsidy would then become an additional profit for the housing suppliers.
Supply-Side Subsidies

A supply-side subsidy would attempt to reduce the price at which suppliers will provide a certain amount of
houses, and this would affect the supply curve by causing it to shift sideways to a new chart location. A new
equilibrium would be established, and prices would decrease while the number of houses provided increases.

Pros and Cons of Subsidies

Subsidies make sense in some situations, but not always. The tool can work well to provide a fix for problems
in the market, such as when a private market doesn't deliver an outcome that works for society. For example,
subsidies can motivate companies to perform research and development in areas that would benefit society,
even if it wouldn't necessarily be a large profit generator for the company. Subsidies can also provide much-
needed help to startups that need to survive an initial period of financial losses until the business matures
enough to become self-sustaining.

On the other hand energy subsidies, for example, are given to low-income families but can become a drain on
government resources, especially if fairly well-off families qualify and take the subsidy. A cash-transfer
program specifically targeted to poor families would cost less money. Additionally, some subsidies such as
those for fossil fuel exploration can be at odds with a society's environmental objectives, such as cleaner air.

Another issue arises when subsidies used to prop up prices artificially cause labor and capital resources to go
to those companies, such as petroleum firms. Meanwhile, the government has fewer resources to give to
newer, alternative-energy companies. Giving subsidies to farmers can support higher produce prices, but
remove any incentives for farmers to become more efficient.