Economics

Study Notes

Development Policies - Removing Government Subsidies

Level:
A Level, IB
Board:
AQA, Edexcel, OCR, IB, Eduqas, WJEC

In many developing countries, a sizeable number of producers especially in farming and energy received subsidies or some other form of government financial support such as a guaranteed minimum price.

Economists who support intervention to promote development argue that subsidies can play an important role in improving (for example) farm incomes which then leads to higher capital investment and supports innovation and improved productivity in the long run.

Subsidies are also a way of encouraging increased production to help overcome the challenges of malnutrition among the poor and they help to generate surpluses for export.

However, free-market critics of subsidies argue that:

  1. Subsidies distort the working of the price mechanism
  2. Subsidies can stifle innovation because producers are less reliant on innovation as a way of making more profit
  3. Producers / growers can become “subsidy-dependent” in the long run and there is also the risk of corruption syphoning off financial support to those who don’t need it
  4. From an environmental point of view, subsidies tend to lower the incentive for producers to improve efficiency, instead they are rewarded by increasing the intensification of farming which can lead to deforestation, a loss of bio-diversity and increased water scarcity. Farmers may overuse fertilisers or pesticides, which can then result in soil degradation which reduces the maximum sustainable yield in the long run

Exam hint:

Go back to your work in Theme 1 (microeconomics) to draw an analysis diagram showing what happens to price, output, consumer and producer surplus if a subsidy is removed. Consider how supplies affected by this might improve their financial position if they can no longer rely on subsidies.

Free-market economists would also make the case for lowering / eliminating subsidies paid to consumers. For example, many developing countries continue to use food-price subsidies or controls in a bid to improve nutrition. Whether this works or not is open to question as households might substitute some of their budget towards foods with less nutritional content because a subsidy effectively increases their real incomes.

Energy subsidies

Energy subsidies are widely adopted in developing countries - the IMF recently estimated that the value of energy subsidies to consumers amounted to nearly 3% of global GDP. Economists concerned about environmental threats from climate change would make the case for getting rid of these subsidies so that the price of energy accurately reflects the externalities involved. There is also a case for cutting subsidies because of the high opportunity cost - perhaps government spending on subsidies might be better allocated to education, health services and public infrastructure?

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