1.4.2 Subsidies

Question 1

Subsidies

Answer 1

Money paid to producers by the government with the aim of encouraging the production and consumption of goods and services with positive externalities (merit goods).

Question 2

What do subsidies do to the supply curve?

Answer 2

A subsidy increases the supply of a good/service, so the supply curve shifts to the right.

Question 3

Give an example of where a government might use a subsidy

Answer 3

A government might provide subsidies for electric cars. This would work to incentivising the consumption of these electric cars because it would reduce the cost of production.

So by subsidising electric cars should reduce the negative externalities of consumption of using a petrol/diesel car.

Question 4

Subsidy diagram

Answer 4

The total cost of the subsidy to the government is shown by the whole rectangle. This consists of consumer gain (shown in blue) plus the total producer gain (shown in purple).

The consumer gain is equal to the fall in price from P to P1. The producer gain is equal to the difference between P and P2.
The subsidy results in the price of the goods/service falling from P to P1, and the quantity demanded increasing from Q to Q1.

The proportion of the subsidy producers and consumers benefit from depends on the elasticity of the supply and demand curves.

Question 5

Advantages of subsidies

Answer 5

• Subsidies can encourage the consumption of merit goods by making them more affordable.
• Subsidies can change presences – producers will supply goods with more positive externalities and consumers will consume them and receive the benefits for them.
• The positive externalities are still present. For example, if a subsidy is paid for wind farms, the wind farm will still reduce pollution levels.
• Subsidies can support a domestic industry until it grows to the point that it can exploit economies of scale and become internationally competitive.

Question 6

Disadvantages

Answer 6

• It can be difficult to put a monetary value on the ‘benefit’ of the positive externalities.
• Any subsidy has an opportunity cost – the money spend on it might have been better spent elsewhere.
• Subsidies may make producers inefficient and reliant on subsidies. The subsidy means that producers have less incentive to reduce costs or innovate.
• The effectiveness of subsidies depends on the elasticity of demand – subsidies wouldn’t significantly increase demand for inelastic goods.
• The subsidised goods and services may not be as good as those they’re aiming to replace. For example, imported goods may be better quality than the domestically produced alternatives that a subsidy is promoting.