Subsidies

• A subsidy is the provision of financial assistance by the government to encourage the production or consumption of a good/service.
• An indirect subsidy is the provision of financial assistance by the government to producers to encourage the production of certain goods/services.
• A government may subsidise the production of a certain good to:

  • Encourage production / consumption of a certain good
  • Make a good more affordable for the poor
• The immediate effect of an indirect subsidy would be to decrease the marginal cost of production, and therefore raise supply.
• Specific subsidy is a fixed amount of subsidy given per unit sold.
• Ad valorem subsidy is a percentage of the price of the good/service or value-added at each stage of production.
• When a subsidy is imposed on a good:

  Government spending: P1 b d P2

  Consumer expenditure: 0 Q1 b P1

  Producer revenue: 0 Q1 d P2

  
• If the market is efficient to begin with, indirect subsidies may distort price signals and lead to a loss of allocative efficiency.
• When a subsidy is imposed on a good, the change in market price and quantity of said good are in opposite directions, hence the final effect on consumer expenditure depends on the PED.
• When a subsidy is imposed on a good:

  Consumer surplus: P1 b e

  Producer surplus: a d P2

  Government spending: P1 b d P2

  Deadweight loss: c b d

  
• Implications of government spending:

  • Worsening of government's budget position
  • Opportunity cost of subsidy
  • Raising taxes from other industries to finance such spending
• When demand is price elastic,

  • Price decreases from P0 to Pe
  • Quantity demanded increases from Q0 to Qe
  • Since change in price < change in quantity demanded, consumer expenditure increases

  
• When demand is price inelastic,

  • Price decreases from P0 to Pi
  • Quantity demanded increases from Q0 to Qi
  • Since change in price > change in quantity demanded, consumer expenditure decreases

  
• Indirect subsidies tend to be regressive in nature leading to greater inequity.
• With the implementation of subsidies on the production of a good, the rise of black markets would occur, where consumers will buy the good at a subsidised price to sell at normal price elsewhere, thus earning a profit.
• If the objective of the indirect subsidy is to lower the price of the good, the policy will be more effective with a more price inelastic demand.
• If the objective of the indirect subsidy is to encourage consumption, the policy will be more effective with a more price elastic demand.