Subsidies content slideshow. Designed for the Economic A level qualification. Can be used in revision and in class. Subtopics Intro to Subsidies Reasons for Subsidies Costs and Benefits of Subsidies Limitations of Subsidies

1. Subsidies
Lower 6th Micro
How Markets Work

2. Intro to
Subsidies
Subsidies
Mr O’Grady

3. Definition: Government support, usually financial, to
suppliers that cover some of their costs.
They increase the supply of the good by artificially reducing
the cost of production
E.g. Agricultural subsidies to food producers, or
apprenticeship schemes
For the A-level, we assume all subsidies shift the supply curve
outward and maintain gradient Quantity
Price S
S + Sub.
Intro to Subsidies
Types of Subsidy:
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).
An input subsidy: Subsidises the cost of inputs used in production – e.g. an employment
subsidy for taking on more workers.
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.
Bail-outs: e.g. for financial organisations in the wake of the credit crunch
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

4. Reasons for
Subsidies
Subsidies
Mr O’Grady

5. Reasons for Subsidies
Impact of Subsidies: Subsidies lead to a lower price and increased quantity traded
of the good or service
Why would a government want to implement a
subsidy?
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
To encourage consumption of merit goods and services
Increased consumption gives increases social benefits
Examples might include subsidies for investment in environmental
goods and services
Quantity
Price S
S + Sub.
D
P
P1
Q1Q
Reduce the cost of capital investment projects
Can help to stimulate economic growth by increasing long-run aggregate supply
Subsidies to slow-down the long term decline of an industry
e.g. fishing or mining
Subsidies to boost quantity demanded for industries during a recession
e.g. the car scrappage scheme

6. Costs and
Benefits of
Subsidies
Subsidies
Mr O’Grady

7. Costs and Benefits of Subsidies
Costs of the subsidy:
Consider a unit subsidy (s) paid on a good
The new equilibrium shows us the quantity traded at the new price
consumers pay (P1)
We can also work out the new price suppliers received by taking this
new quantity and applying it to the old supply curve (P2)
This is the same as adding the unit value of the subsidy to the new price
(P1 + s = P2)
The total government spending made is equal to the unit subsidy
times the quantity traded, s x Q1 (or (P2-P1) x Q1), shown by the
orange dotted rectangle
Benefit to consumers:
Consumers were previously paying P, but they now only have to pay
P1
This increases the consumer surplus as more goods are consumed at
a lower price, shown by the pink area
Benefit suppliers:
Suppliers were previously receiving P, but they now receive P2
This increases the producer surplus as more goods are sold and suppliers receive a higher price, shown by the
blue area
Overall: In total, the subsidy increases CS and PS, but not by the same value as the subsidy costs
the government
There is hence a DWL, equal to the amount of government spending that does not become new welfare, shown
by the red triangle
Quantity
Price S
S + Sub.
D
P
P1
Q1Q
P2
DWL
s

8. Impacts of a subsidy and PED
Elastic PED:
Producers get
most of the
benefit
Shown by the
blue area
being larger
than the pink
Perfectly
Elastic PED:
Producers get
all the benefit!
Consumers
continue to
pay the same
price
Inelastic PED:
Consumers get
most of the
benefit
Shown by the
pink area
being larger
than the blue
Perfectly
Inelastic PED:
Consumers get
all the benefit!
Producers
continue to
receive the
same price
Quantity
Price S
S + Sub.
D
P
P1
Q1Q
P2
s
DWL
Quantity
Price S
S + Sub.
DP
Q1Q
P2
s
DWL
Quantity
Price S
S + Sub.
D
P
P1
Q1Q
P2
s
DWL
Quantity
Price S
S + Sub.
D
P1
Q
P
s

9. Limitations of
Subsidies
Subsidies
Mr O’Grady

10. Limitations of Subsidies
Productivity effects: If the subsidy is too generous, it can lead firms to become
over reliant on government support
Inefficient and high cost ‘zombie’ businesses can persist into the long run when their
resources could have been better used elsewhere
The operation of the free market is distorted
Can be ineffective: If demand is inelastic, subsidies have little effect on the amount
consumed
The subsidy represents a large opportunity cost to the government with limited gains for
producers
Funding: Sometimes a subsidy can be self funding, if the improved revenue for
businesses can generate more tax revenue for the government
However, this won’t always be the case, particularly for struggling industries
A subsidy could hence create an expensive extra burden for taxpayers
Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments
E.g. the system of CAP farm subsidies have been heavily criticised for the level of fraud
involved
Limits the extent to which CS and PS are both increased

11. Where next?
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