Effects of Subsidies

Sometimes the government may feel like a certain good is not being produced enough. So, they try to make the production of that good attractive. They do this through subsidies. It's like free money! The government goes like, "Hey, want to farm extra peaches for some free cash?" And the peach farmers are like, "sure, why not?" Just like that, a subsidy takes place. Anyway, we're here to discuss the effect of subsidies on consumer and producer surplus as well as some examples of subsidies.

Effects of Subsidies Effects of Subsidies

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Table of contents

    Subsidies Definition

    Subsidies are a way for the government to intervene in the market and restore efficiency. But, what are they? Subsidies are benefits provided by the government to producers. They are usually financial and come in the form of tax pardons or cash payments.

    Subsidies are benefits, usually financial, provided by the government to producers.

    In the case of tax pardons, the government exempts certain producers from paying taxes. However, in the case of cash payments, the government provides cash to certain producers of certain goods to boost the supply of those goods.

    That's it! You just defined subsidies. Let's end the definition with an example.

    The government finds out that bicycles are good for the environment and help reduce carbon emissions, which benefits society as a whole. However, not many producers are making bicycles because they find them too expensive to make. The government realizes this and provides one million dollars to producers to make bicycles.

    In the above example, we can say that the production of bicycles has been subsidized and that the government provides a subsidy of one million dollars to bicycle producers!

    Impacts of Subsidies

    The general impact of subsidies is that they make it easy for firms to produce certain goods. After all, they're being assisted with free cash or tax pardons. These tax pardons or cash payments reduce the production expenses producers have to bear. In the end, consumers will be paying less for the subsidized product. From this, we can tell that there are two general impacts of subsidies:

    1. The first impact of subsidies is the reduction in both production costs and the price of the commodity, making consumers buy more of that product.

    2. The second impact of subsidies is that more firms will enter the market for subsidized products since it is now affordable for them to produce!

    Here is an example.

    As part of plans to encourage the use of solar energy, the government subsidizes solar panels and causes more firms to enter the production of solar panels. This increases the supply of solar panels. At the same time, the consumers realize that solar panels have been subsidized, so they're cheaper. This then increases the demand for solar panels!

    Effects of Subsidies on Consumer Surplus

    The effect of subsidies on consumer surplus is that it increases it. This is because the consumer surplus represents the difference between what consumers are willing to pay and what they actually pay for the commodity. This is derived from the subjective value we attribute to purchasing things.

    The consumer surplus represents the difference between what consumers are willing to pay and what they actually pay for the commodity.

    Why do subsidies cause the consumer surplus to increase? Let's explain this with an example!

    Kent was initially budgeted $500 for a bicycle. He buys the bicycle and finds out that bicycles are going for $500. If Kent decides to buy the bicycle, there will be no consumer surplus because the price of bicycles is equal to his budget. Now, let's say the government subsidizes bicycle production, and bicycles cost $400 now. This means that Kent has a positive consumer surplus of $100 now.

    The above example shows the effect of subsidies on the consumer surplus in a very simplified form! Figure 1 highlights the consumer surplus on the subsidy effect model.

    Effects of Subsidies, Consumer Surplus Model, StudySmarterFigure 1. Consumer surplus on the subsidy effect model, StudySmarter Originals

    As shown in Figure 1, the initial price consumers had to pay was P1. Since P1 is the price consumers were willing to pay in the first place, there is only consumer surplus (CS) for those willing to pay more than P1. However, the subsidy helps reduce the price (from P1 to P2). This results in a consumer surplus covered by the area above the supply curve between P1 and P2.

    Effects of Subsidies on Producer Surplus

    The effect of subsidies on the producer surplus is that it increases it! The producer surplus is the difference between what producers are willing to supply goods for and what they actually receive for supplying the goods. This occurs for producers as their marginal cost rises with each additional unit, so the early units produced are cheaper than the end selling price.

    The producer surplus is the difference between what producers are willing to supply goods for and what they actually receive for supplying the goods.

    Let's explain how subsidies cause the producer surplus to increase using an example!

    A solar panel manufacturer spends $100 to make a solar panel, which it is willing to sell for $100 apiece. However, consumers are only willing to buy one solar panel for $90, making the producer surplus -$10. As a result, the producer decides not to sell and stops producing, and there is a shortage of solar panels. The government sees this and gives the company $20 for each solar panel produced. This means that the company will now receive $110 for each product, and the producer surplus is now $10.

    The above example shows the effect of subsidies on the producer surplus in a very simplified form! Look at Figure 2 as it highlights the producer surplus. Now, let's go into some detail. Read on!

    Effects of Subsidies, Producer Surplus on Model, StudySmarterFigure 2. Producer surplus on the subsidy effect model, StudySmarter Originals

    Looking at Figure 2, the initial price consumers were willing to pay was P1. This only provided some producer surplus (PS). However, the subsidy helps increase the price producers receive (from P1 to P3). This results in a producer surplus covered by the area between P1 and P3.

    Effects of Subsidies on the Economy

    Subsidies are used to support critical industries, fund research, and maintain minimum standards of living. Subsidies also affect the determinants of supply, often for the better in the short run, however, they can have consequences for some.

    The most common subsidies are in food production, which most countries in the world use some form of. This helps a nation keep its food production industry healthy to keep the population satiated.

    However, these subsidies in food production can hurt international trade, many have complained that Chinese farmers are out-competing others due to unfair subsidy advantages.1

    The effect a subsidy has on the market depends on the elasticity of supply and demand within the target market.

    This can vary greatly, demand for food is usually inelastic as humans need to eat the same amount of food whether they're rich or poor. In this case, subsidizing food can save consumers money, but they typically aren't buying more even with the artificially low price.

    Love the Subsidies, Hate the Taxes.

    Celebrity icon Elon Musk has been an outspoken critic of forms of wealth taxes or corporate tax hikes. While it's true these taxes would hurt his business and even reduce efficiency and natural market competitiveness.

    It's also important to note that Elon Musk's businesses have received subsidies and government benefits for decades. According to a business insider article "Musk's companies had received an estimated $4.9 billion in government support by 2015, and they've gotten more since."2

    Where did that government support money come from, was it from taxes?

    Taxes are used to fund subsidies that provide research grants which lead to advances in technology. Firms are then able to buy this technology sooner, as researchers can leverage more risk and the technological advancement will cost less since the research was publicly funded.

    This can be seen in the deep dive above, as Elon Musk has used government subsidies to build profitable and effective technological advancements and products. However, governments must collect taxes to be able to give out the support money that helped build his empire.

    Effect of Subsidy on Supply and Demand Graph

    Below is a graphical representation of how a subsidy affects a market at equilibrium.

    The subsidy splits the benefit, where suppliers get a higher price, at the same time as consumers receive a lower price. How is this possible, read the example below for specific details.

    It's important to note that this graph represents the change in surplus as a result of the subsidy, the surplus shown is not the entire market surplus.

    Deadweight Loss occurs in the market as a result of providing the goods beyond the equilibrium quantity. Of the total tax dollars required for this subsidy most of the cash creates a surplus, however, because the value of transactions after equilibrium is diminished by marginal returns, not all of the subsidy's value is realized.

    Effects of Subsidies, Subsidy Effect Model, StudySmarter Figure 3. Subsidy Effect Model, StudySmarter Original

    While using the graph provided in figure 3, Consider the market of Brussel Sprouts:

    Try your best to imagine an evil government that hates happiness and wants your parents to make you eat brussel sprouts, so they put a $2 subsidy on Brussel sprouts. This means that the government tells producers to sell to consumers for $2 and the government will give $2 for each unit sold.

    The market at equilibrium previously had a quantity(Q1) of 750 brussel sprouts for a price of $3(P1). With the subsidy, farmers must agree to sell at $2(P2), though the subsidy will pay farmers an additional $2 meaning they receive $4(P3) for each sale.

    So consumer price is $2(P2) and Producers receive $4(P3)

    This change in price increases the quantity (from Q1 to Q2) supplied and demanded.

    750(Q1) brussel sprouts to 1000(Q2)

    Q1=750 Q2=1000 P2=$2 P1=$3 P3=$4 Tax Burden=$2000


    To calculate the increase in consumer surplus,

    We find the area of the triangle right of Q1 below the demand curve

    ((P1-P2)*(Q2-Q1)*0.5) = (3-2)*(1000-750)*0.5 = (1)*(250)*0.5 =$125

    And add it to the consumer surplus rectangle

    ((P1-P2)*Q1) = ((3-2)*750) = $750

    $750+$125=$875 increase in consumer surplus


    To calculate the increase in producers' surplus,

    We find the area of the triangle right of Q1 above the supply curve

    ((P3-P1)*(Q2-Q1)*0.5) = (4-3)*(1000-750)*0.5 = (1)*(250)*0.5 = $125

    And add the producer surplus rectangle

    ((P3-P1)*Q1) = ((4-3)*750) = $750

    750+125=$875 increase in producer surplus


    Deadweight loss is found by calculating the area of a triangle

    ((P3-P2)(Q2-Q1)0.5) = (4-2)(1000-750)*0.5 = 2*250*0.5 = $250 DWL

    In the example above, the government pays $2000 to subsidize brussel sprouts. Consumer and producer surplus both increase $875 more than their previous surplus. The total surplus created by the subsidy is $1750, which means that $250 of value is not realized and becomes a deadweight loss.

    This $250 DWL is a result of customers who don't value the good enough to buy it normally. Similarly, producers can increase the quantity, but at a high cost, so it incentivizes inefficient production for higher quantity. However, it's important to weigh the $250 DWL against the $1750 gain in the total market.

    Government intervention in the market through subsidies does create a benefit but it is not a 100% return on investment. Due to the nature of diminishing utility, the additional sales created by the subsidies don't generate as much value as the tax dollar injected.

    It's important to consider what alternatives the tax dollars used for subsidies can create. Fiscally conservative individuals would say that they should decide where to spend their money, rather than the government. This actually would eliminate the deadweight loss, as consumers can buy things that maximize their utility.

    When governments collect taxes it lowers consumers' ability to maximize personal utility, and the government expenditures are not as efficient as in a competitive market. Overall, government intervention done to efficient markets can only hurt the market.

    Examples of Subsidies

    Examples of subsidies in the US are subsidies on agricultural produce, healthcare, and housing among other subsidized products. Let's describe some examples below.

    First, let's look at a producer surplus.

    Fuel producers in the US are willing to supply fuel at $7 per gallon of fuel. However, consumers are only willing to pay $4 per gallon. This means there will not be enough for a producer surplus, and as a result, there is a fuel shortage. The government sees this and decides to provide a subsidy of $4 per gallon. This encourages the producers to resume production as there is now a producer surplus.

    Now, let's look at a consumer surplus.

    Food stamps are an example of a subsidy. For those consumers who may not be able to afford groceries and other food items, it's not profitable for producers to give them these items. Therefore, the government intervenes and provides food stamps with benefits loaded on them. This way, the government pays the producers, the consumers also get food, and there is a consumer surplus.

    That's it! You reached the end of the article! You should read our article on Taxes and Subsidies to improve your understanding of the topic.

    Effects of Subsidies - Key takeaways

    • Subsidies are benefits, usually financial, provided by the government to producers.
    • The consumer surplus represents the difference between what consumers are willing to pay and what they actually pay for the commodity.
    • The producer surplus is the difference between what producers are willing to supply goods for and what they actually receive for supplying the goods.
    • The general impact of subsidies is that they make it easy for firms to produce certain goods. The first impact of subsidies is the reduction in both production costs and the price of the commodity, making consumers buy more of that product. The second impact of subsidies is that more firms will enter the market for subsidized products since it is now affordable for them to produce!
    • Examples of subsidies in the US are subsidies on agricultural produce, healthcare, and housing among other subsidized products.

    References

    1. Michael Martina and David Lawder, Exclusive: China offers to end market-distorting subsidies but won't say how, 2019. https://www.reuters.com/article/us-usa-trade-china-subsidies-exclusive/exclusive-china-offers-to-end-market-distorting-subsidies-but-wont-say-how-idUSKCN1Q32X6
    2. Jason Lalljee, Elon Musk is speaking out against government subsidies. Here's a list of the billions of dollars his businesses have received, 2021. https://www.businessinsider.com/elon-musk-list-government-subsidies-tesla-billions-spacex-solarcity-2021-12?r=US&IR=T
    Frequently Asked Questions about Effects of Subsidies

    How do businesses benefit from subsidies?

    Their production costs decrease and their producer surplus increases.

    What are subsidies?

    Subsidies are benefits, usually financial, provided by the government to producers.

    What is the economic effects of subsidies?

    Subsidies cause both the consumer and producer surpluses to increase.

    What is the effects of government subsidies?

    The first impact of subsidies is the reduction in both production costs and the price of the commodity, making consumers buy more of that product.

    The second impact of subsidies is that more firms will enter the market for the subsidized product since it is now affordable for them to produce!

    What are the advantages and disadvantages of subsidies?

    Advantages:

    Subsidies make goods affordable

    Subsidies promote positive externalities

    Disadvantages:

    Overproduction

    Higher taxes


    Test your knowledge with multiple choice flashcards

    Subsidies cause the producer surplus to decrease.

    Subsidies cause the consumer surplus to increase.

    Subsidies cause more firms to leave the market.

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