A subsidy is a payment given to a business by the government in order to cover part of the cost of production and encourage an increase in consumption. It is financial assistance that is aimed at lowering the prices of essential products, such as food and public transport. A subsidy has the opposite effect of an indirect tax: it increases supply by shifting it rightwards, lowers the price and increases the quantity traded in the market. The vertical distance between the before-subsidy and after-subsidy supply curves is the subsidy per unit (see Figure 1 below).
Figure 1: Graph showing the distribution of subsidy
Consequences of subsidy
Subsidy increases the supply of a product and lowers its price in order to make it more affordable. In Figure 1 above, supply increased from S1 to S2, price reduced from P1 to P2 and quantity increased from Q1 to Q2. It prevents the scarcity of essential goods by offering support to the producers. Therefore, it does not allow the producers to cease operations owing to the inability to sell enough quantity to cover their costs. Export-oriented businesses can also enjoy this type of financial assistance that will help increase their production for export, thereby reducing imports and improving the balance of payments.
The government can use subsidies to correct the market failure of underprovision and underconsumption of merit goods such as education and health. These products have positive effects on the society not only on the consumers. The government finds it desirable to have more of these goods within the reach of the citizens. So, the government subsidises them in order to encourage more production and consumption.
But subsidies are expensive because they may deprive the government of funds for other developmental projects such as the provision of infrastructures. In addition, over-reliance on subsidies does not encourage efficiency. The firm would be reluctant to cut its costs or reallocate its resources to a more profitable product.
The distribution of the benefit of subsidy
The producers do not pass the entire benefit to the consumers by lowering the price by the whole amount of subsidy per unit. Rather, the benefit is shared by both the producers and the consumers. The consumers benefit by paying a lower price (P2 in Figure 1 above) than the initial equilibrium (P1 in Figure 1 above). In other words, the price paid by the consumers P2 decreased by P1-P2. The producers retained a portion of the subsidy to cover part of the cost of production. The price received by producers P3 is higher than the original equilibrium price P1. The total amount of subsidy is represented by the area of rectangle P3P2AC; the part of the subsidy distributed to the consumers is shown by the area of rectangle P1P2BC and the producers’ share of the subsidy is represented by the area of rectangle P3P1AB.
Subsidy and price elasticity of demand
The benefit of the subsidy is determined by the magnitude of the subsidy and the elasticity of demand. The larger the value of the price elasticity of demand, the smaller the subsidy benefit to the consumers. If demand for a product is relatively inelastic, the percentage change in price is more than the change in quantity. Therefore, there is a larger price fall arising from granting subsidies. The consumers’ benefit is larger than the benefit to the producers because they pay a much lower price (Figure 1 above).
The consumers enjoy a smaller part of the subsidy if demand is fairly or relatively elastic because the price fall is smaller than the quantity increase. Therefore, the producers’ share of the subsidy is larger than what the consumers enjoy (Figure 2 below).
Figure 2: Graph showing subsidy distribution when demand is fairly elastic
Subsidy becomes most effective when demand is perfectly inelastic because that is when the highest price fall occurs. Therefore, the consumers enjoy the greatest benefit from granting subsidies to producers by the government. All the benefit of the subsidy goes to the consumers. In Figure 3 below, the whole subsidy, shown by the area of rectangle P1P2GH, is enjoyed by the consumers. The price paid falls by the whole amount of subsidy per unit (P1-P2).
Figure 3: Graph showing subsidy distribution when demand is perfectly inelastic
The consumers do not derive any benefit from subsidy if demand is perfectly elastic. The whole subsidy is kept by the producers (rectangular area IP1JK in Figure 4 below).
Figure 4: Graph showing subsidy distribution when demand is perfectly elastic
Subsidies and the price elasticity of supply
If demand is more elastic than supply, the consumers’ share is smaller. If supply is more inelastic than demand, the consumers’ share of the subsidy is smaller than the producers’ share (see Figure 2 above). But if supply is more elastic than demand, the consumers’ benefit from a subsidy is larger than that of the producers (see Figure 1).