Micro booklet 4

Question 1

Show me subsidy and economies of scale

Answer 1

Subsidies reduce firms’ cost of production and mean that firms can make more profit at any given price. This increases the incentive to supply and causes the supply curve to shift to the right from S1 to S2. Excess supply at the equilibrium price of P1 causes the market price to fall to P2 and triggers an extension of demand to Q2.
If the increase in quantity from Q1 to Q2 involves some firms increasing in scale of production then they may experience economies of scale, lowering long-run average costs and causing further increases in profitability and the incentive to supply, with supply shifting to the right again at S3. This causes a further fall in price to P3 and another extension of demand to Q3.