producer subsidies

Subsidies represent payments to producers by the government which reduce their variable costs of production and encourages them to expand their output. 

The effect of a subsidy with a downward sloping demand curve is to increase the quantity of goods sold and to reduce the market equilibrium price. This is shown in the diagram below

Government subsidies are often offered to producers of merit goods and services and industries requiring some protection from low cost international competition.

The more inelastic the demand curve the greater the consumer's gain from a subsidy will be. Indeed when demand is perfectly inelastic the consumer gains the entire subsidy because the market price will fall by the entire amount of the subsidy. When demand is relatively elastic, a subsidy will have more of an impact on quantity bought and sold and will cause only a small fall in the market price.

Producer subsidies may also come in the form of guaranteed minimum prices from the government (or some other central buying agency. In the diagram below, the government established a guaranteed minimum price. The effect would be that a surplus equal to quantity AC appears in the market. Supply at the minimum price has expanded, but demand contracts. In order for the minimum price to be maintained, the government would have to purchase quantity AC at the minimum price.

Government spending on a subsidy

If the subsidy is a guaranteed payment to producers, the government will pay the subsidy per unit to the producer on top of the new market price. The subsidy reduces equilibrium price from P2 to P1. Consumers gain from consuming more at a lower price. Producers will receive price P1 + the subsidy (P1P3). The total amount spent by the government on the subsidy will be Q1 x (P1P3). This is shown in the diagram below.

The risks associated with subsidies

Subsidies are not without controversy. There are occasions when we might justify a government subsidy - for example to encourage the production and consumption of goods and services that create positive externalities (see also merit goods and services).

However we must remember that subsidies need to be financed. Often this is done out of general taxation. The case for a subsidy should be judged on the grounds of economic efficiency and also fairness. We need to be careful to evaluate who gains from any particular subsidy and who pays - might the money used up in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an opportunity cost.

Subsidies may also encourage continued inefficiency among producers when the operation of free market forces might result in a more efficient allocation of resources. There are also widespread concerns that generous agricultural subsidies are leading to long-term environmental problems as farmers invest in intensive farming methods that threaten the sustainability of our ecological resources

The economic and social case for a subsidy should be judged on the grounds of economic efficiency and also fairness. We need to be careful to evaluate who gains from any particular subsidy and who pays. Might the money used up in subsidy payments be better spent elsewhere? Government subsidies inevitably carry an opportunity cost - there are signs that the Labour Government is now reviewing its strategy towards industrial subsidies in the aftermath of the June 2001 General Election win.

The new trade secretary Patricia Hewitt has announced a comprehensive review of government subsidies to failing industries. In her first major speech, she said that her department's £1bn a year business support scheme could be better targeted to help firms "get to the future first

It's not about protecting business or employees from the enormous changes that are taking part in the world. It's about helping them not only survive these changes but also succeed through change," she said. Ms Hewitt pointed out that while steel, shipbuilding, and cars received large grants, other struggling industries such as textiles did not.