Should government money be used in subsidies to help businesses in financial trouble? The age-old issue of the arguments for and against subsidy has resurfaced in recent years as several sectors of the economy have experienced difficulties. They range from farming to coal mining to steel production and the aviation industry.

Government Subsidy

A subsidy is a payment by the government to suppliers that reduce their costs of production and encourages them to increase output. The effect of a government subsidy is to increase supply and (ceteris paribus) reduce the market equilibrium price. The subsidy causes the firm's supply curve to shift to the right. The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output. Occasionally the government can offer a direct subsidy to the consumer – which has the effect of boosting demand in a market
Different Types of Producer Subsidy

1. A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price offered to farmers
2. An input subsidy which subsidises the cost of certain inputs used in production – e.g. an employment subsidy for taking on more employees
3. Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry
4. Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e.g. as part of a regional policy designed to boost employment

Showing the effect of a subsidy to producers

To what extent will a subsidy feed through to lower prices for consumers? This depends on the price elasticity of demand for the product. The more inelastic the demand curve the greater the consumer's gain from a subsidy. Indeed when demand is perfectly inelastic the consumer gains most of the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price. When demand is relatively elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a much lower market price.

The Economic and Social Justifications for Subsidies

Why might the government be justified in providing financial assistance to producers in certain markets and industries? How valid are the arguments for government subsidies?

1. To control the rate of inflation and boost the real living standards of some groups of consumers – for example lower income households.
2. To encourage the provision and consumption of merit goods and services which are said to generate positive externalities (increased social benefits). Under-consumption or provision of merit goods can lead to market failure causing a loss of social welfare
3. Maintain or increase the revenues (incomes) of producers during times of special difficulties in markets (consider some of the examples mentioned below)
4. Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply
5. Subsidies to smooth or slow-down the process of long term structural change/decline in an industry (for example in farming, coal, fishing and steel)
6. Boost employment for certain groups of workers e.g. the long term unemployed

Economic Arguments against Subsidies

The economic and social case for a subsidy should be judged carefully on the grounds of economic efficiency and also fairness (or equity). We need to be careful to measure and 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 and in the long run there might be better ways of providing financial support to producers and employees in specific industries.

Free market economists argue that government subsidies distort the workings of the free market mechanism and can eventually lead to government failure where government intervention actually leads to a worse distribution of resources.

1. Distortion of the Market: Subsidies distort market prices - this can lead to a misallocation of resources – many economists believe that the free-market mechanism works best. Export subsidies distort the free trade in goods and services and can severely curtail the ability of ELDCs to compete in the markets of industrialised countries
2. Arbitrary Assistance: Decisions about which groups or industries receive a subsidy can be arbitrary – if tourism is supported, why not the British steel industry?
3. Financial Cost: Subsidies can become expensive – note the opportunity cost!
4. Who pays and who benefits?: The final cost of a subsidy usually falls on consumers (tax-payers) who themselves may have derived no benefit from the subsidy
5. Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to restructure – i.e. it delays much needed economic reforms
6. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments
7. There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects, for example by direct income support through the tax and benefit system