Subsidies: Study with Video Lessons, Practice Problems & Examples

Government subsidies function similarly to taxes, affecting market participants by redistributing benefits rather than burdens. When a subsidy is applied, the demand curve shifts right, leading to different prices for buyers and sellers. The benefits of the subsidy are split based on price elasticities; the more inelastic party receives a greater share. This creates a deadweight loss due to over-trading, as resources could have been allocated more efficiently. Understanding these dynamics is crucial for grasping the implications of fiscal policy on market equilibrium.

Subsidies

Now let's see how the effects of a government subsidy are actually very similar to the effects of a tax. So remember when the government gives a subsidy, it's the opposite of a tax, right? With a tax, the government is taking away money from the market participants, whereas with a subsidy, the government gives money to a market participant, right? We're still going to be dealing with that idea of a per unit subsidy, right? There's going to be almost like they're giving a negative tax, right. They've imposed a negative tax where they're going to give money away. So what you're going to see is that we're actually going to see very similar conclusions, but they're just going to happen on the other side of the graph. First, we're going to see that the party receiving the subsidy doesn't get the full benefit, right? So, just like we saw with the tax, whoever paid the tax, there was a tax incidence to the consumer and a tax incidence to the producer. So they actually split that burden of the tax between the two. We'll see the same thing with subsidies where they're going to split the benefit and we're going to see that the split, right, how it's split, it's not just going to be 50/50. It's going to depend on those price elasticities just like we saw with taxes. And last, we're going to see this deadweight loss, right? With taxes, we saw a deadweight loss from undertrading, right? The tax caused us to be at some quantity below equilibrium; a subsidy is going to push us to a quantity past equilibrium, right? So we're going to be overtrading and the idea there is that the resources we spent overtrading could have been spent somewhere else creating some other good and had a better purpose, right? So we overtraded and it created a deadweight loss because we passed equilibrium. So that's how they're the same. We're also going to see that there are a couple of things that are different. First, with the subsidy, remember the tax shifted the curve to the left, right? If the consumers got taxed, the demand curve shifted to the left. Well, we're going to see the opposite here, right, because the government is actually giving money to the consumer or to the producer. We're going to see this curve shift to the right, by the amount of the subsidy. Okay? And last, remember when we saw taxes we saw that the price the buyer paid was different from the price the seller received, right? There were two different prices and we're going to see the same thing, two different prices, but now they're going to be inverted because since the government is giving money, you're going to see that the price the seller receives is higher than the price the buyer pays. Right? The buyer pays $5 and the government subsidizes an extra dollar. Now the supplier is receiving $6, right? So the supplier is receiving more money than the buyer paid because of that government money coming in. So let's go ahead and see how the elasticities, right? They're going to show us how the benefit gets split. So we'll do that here on the graphs, but I guess first let's talk about the subsidy and like let's look at it here on the graph first. So we've got our standard kind of situation where we've got our p* right, we had our equilibrium price and quantity, we've got our downward demand here and our upward supply right? And then the government steps in and it gives a subsidy, right, in this amount. Right, that's the amount of the subsidy right there and we're going to have two new prices now, right? Since the government's going to put money in here, the price the seller receives and the price the buyer pays are going to be different now. So which one do you think is going to be the price the supplier receives and which one do you think is going to be the price the seller received. Well in this case, it's going to be the opposite. The price the buyer pays is going to be less because of the subsidy, alright? And that may also make sense because if you look on this demand curve, the demand curve is the one that's touching the dot way down here, right? So that dot down there is going to be the price the buyers pay because that's where it touches the demand curve, and right here the price the seller receives is right up there touching the supply curve. Right, so there you see the different prices and now let's go ahead and see how this benefit is split, right? So we've got that subsidy right there. So what do you think? Which piece is bigger, right? We've got this big piece down here of the subsidy and then this little piece of the subsidy over here. So before we make our conclusion, let's look at the shape of the curves. We've got elastic supply and inelastic demand, right? Supply is elastic; it looks like it's almost laying down, right? And the demand is inelastic. It's almost standing straight up, right? So with that inelastic demand and elastic supply, who's going to get more of the benefit? Well, it's this bottom piece, right? But who does that bottom piece belong to? When we were doing taxes, the bottom part was for the supplier, and the top part was for the consumer, right? And that made sense because we were on the left side of the graph, but here on the right-hand side, it's actually the opposite. If you'll notice when we're on the right-hand side of the graph, the demand curve is on the bottom, and the supply curve is on top here, right? So it's since the demand curve is on the bottom, the bottom part there is for the consumers. So here the consumers are getting a big part of the benefit and the suppliers are getting that little part of the benefit, right? And who was more inelastic here? The consumers, right? And the consumers got more benefit. So we're going to see how this kind of relates to what we did with taxes. But let's go ahead and confirm it on this right-hand graph and do one more example where now the supply is inelastic and the demand is elastic. So let me get out of the way, so we can label the graph and stuff and let's start here with our equilibrium. Right? We've got P* and this was our Q* right here. Oh, and just to reiterate, right, in this first graph here at the subsidy, right, this is the quantity that's going to be exchanged over here right? The quantity, I'll put H, the high quantity that's going to be exchanged because of the subsidy. We're trading past equilibrium, right? Here on this graph, it's going to be out here right? This is our going to be our high quantity over here. Okay. So we've got our demand curve and our supply curve, right, and you can see that the supply is inelastic; it's almost standing straight up. The elastic demand is almost laying down. Right? So again, the government steps in, gives this subsidy right here, and how's it going to be split? I guess first, let's put our prices for the buyer and the price for the seller. So what do we got here? Again, we're going to see that the price to the seller, right there where it's touching the supply curve, is way up there and down here we got the price to the buyer, right? A lower price and then the government fills in that gap and gives the supplier more money, right? Okay. So let's go ahead and see how this one is split. Right. So now we can see that this one's the small one down here, right, and this is the big one And who's more inelastic in this case? The supplier, right? And who's getting more of that benefit? The supplier, right? Because the suppliers on the top part of this graph. The supply curb is right here. Right? So that's the supplier side of the graph, and this is the consumer down here. Right? So here, we're seeing the same conclusion, right, where the inelastic party, the Inelastic party is getting more benefit, right? And that's what we saw with tax, the Inelastic party paid more tax. Okay, so we're going to see that we can make the same conclusion here. The curve that is more inelastic represents the group who will receive more tax benefit, right? More inelastic, more tax benefit. So if the demand curve is more inelastic, consumers get more benefit. And if the supply curve is more inelastic, right, the suppliers get more benefit. So what do we see? We see that conclusion is going to parallel what we saw with taxes. Whoever pays more tax gets more subsidy benefit, right? The more inelastic party is going to get more tax and they're also going to pay more subsidy benefit or get more subsidy benefit. Okay? So that's how the subsidies kind of relate to the tax. You see there's a lot of similarities there. Alright. Let's go ahead and go on to the next video.

A government wants to increase the use of solar panels by offering a $100 subsidy for each solar panel purchased. The addition of this subsidy will:

• A. Increase the quantity supplied
• B. Decrease the quantity supplied
• C. Create a deadweight loss in the market for solar panels
• D. Both (a) and (c)

The government wants to help producers of a life-saving machine, so they introduce a $1,000 subsidy per machine produced. Assuming that demand for this machine is inelastic, the subsidy will:

• A. Increase the price paid by consumers by $1,000
• B. Increase the price paid by consumers by less than $1,000
• C. Decrease the price paid by consumers by less than $1,000
• D. Have no effect on the price paid by consumers

Here’s what students ask on this topic:

What is the impact of government subsidies on market equilibrium?

Government subsidies shift the demand curve to the right, leading to a higher quantity exchanged than at equilibrium. This results in different prices for buyers and sellers: the price paid by buyers decreases, while the price received by sellers increases due to the subsidy. The benefits of the subsidy are split based on the price elasticities of demand and supply. The more inelastic party receives a greater share of the subsidy. However, this also creates a deadweight loss because resources are over-allocated to the subsidized market, which could have been used more efficiently elsewhere.

How do subsidies create deadweight loss in the market?

Subsidies create deadweight loss by pushing the quantity exchanged past the market equilibrium. This over-trading means that resources are being used inefficiently. The additional units produced and consumed due to the subsidy could have been allocated to other areas where they might have generated more value. This misallocation of resources results in a loss of economic efficiency, known as deadweight loss, because the cost of the subsidy exceeds the benefits derived from the additional production and consumption.

How are the benefits of a subsidy split between consumers and producers?

The benefits of a subsidy are split between consumers and producers based on the price elasticities of demand and supply. If the demand is more inelastic than the supply, consumers will receive a larger share of the subsidy benefit. Conversely, if the supply is more inelastic than the demand, producers will receive a larger share. This is because the more inelastic party is less responsive to price changes, allowing them to capture a greater portion of the subsidy.

What are the similarities between the effects of taxes and subsidies on market participants?

Both taxes and subsidies affect market participants by altering prices and quantities exchanged. With taxes, the burden is split between consumers and producers based on price elasticities, leading to a decrease in the quantity exchanged and a deadweight loss from under-trading. Subsidies, on the other hand, provide benefits that are also split based on elasticities, but they increase the quantity exchanged, resulting in a deadweight loss from over-trading. In both cases, the more inelastic party bears more of the tax burden or receives more of the subsidy benefit.

How do price elasticities affect the distribution of subsidy benefits?

Price elasticities determine how the benefits of a subsidy are distributed between consumers and producers. If the demand is more inelastic than the supply, consumers will receive a larger share of the subsidy benefit because they are less responsive to price changes. Conversely, if the supply is more inelastic than the demand, producers will receive a larger share. This is because the more inelastic party can capture a greater portion of the subsidy, as they are less likely to change their behavior in response to price changes.