What effect does a producer subsidy have on market price and output?

• State subsidises are financed from general taxation or by borrowing
• 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
• A direct subsidy to the consumer has the effect of boosting demand i.e. an outward shift of demand

Showing a producer subsidy in a supply and demand diagram

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 such as under the old-style Common Agricultural Policy (CAP).
2. An input subsidy which subsidises the cost of inputs used in production – e.g. an employment subsidy for taking on more workers.
3. Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry or a loss-making airline.
4. Bail-outs e.g. for financial organisations in the wake of the credit crunch
5. 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

How do we show the total government spending on a producer subsidy?

To what extent will a subsidy feed through to lower prices for consumers?

This depends on price elasticity of demand. 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 price elastic, the main effect of the subsidy is to increase the equilibrium quantity traded rather than lead to a much lower market price.

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 keep prices down and control inflation – in the last couple of years several countries have been offering fuel subsidies to consumers and businesses in the wake of the steep increase in world crude oil prices.
2. To encourage consumption of merit goods and services which are said to generate positive externalities (increased social benefits). Examples might include subsidies for investment in environmental goods and services.
3. Reduce the cost of capital investment projects – which might help to stimulate economic growth by increasing long-run aggregate supply.
4. Subsidies to slow-down the process of long term decline in an industry e.g. fishing or mining
5. Subsidies to boost demand for industries during a recession e.g. the car scrappage scheme

Example: Why subsidise public transport such as local bus or rail services?

• Move output away from the market to social optimum level so improving allocative efficiency
• Encourages a modal shift away from private cars and so create positive externalities and improves sustainability

Improve social equity and reduce social exclusion as low income households who cannot afford cars now have access to transport

Overview of the economic effects of subsidies

Economic Arguments against Subsidies

• The economic and social case for a subsidy should be judged carefully on the grounds of efficiency and fairness
• 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 workers in specific industries.
• Free market economists argue that subsidies distort the working of the free market mechanism and can lead to government failure where intervention leads to a worse distribution of resources.

1. Distortion of the Market: Subsidies distort market prices – for example, export subsidies distort the trade in goods and services and can curtail the ability of ELDCs to compete in the markets of rich nations.
2. Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary, based on political aims
3. Financial Cost: Subsidies can become expensive in the long run – note the opportunity cost!
4. Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or 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 reforms.
6. Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments (the system of CAP farm subsidies have been heavily criticised for the level of fraud involved)
7. There are alternatives: It may be possible to achieve the objectives of subsidies by alternative means which have less distorting effects.

Subsides used in isolation are less effective than if part of strategic integrated solution to a particular economic / social problem

Revision on other types of government intervention:

Quizlet Revision Activity on Government Intervention