Subsidies: Study with Video Lessons, Practice Problems & Examples

Government subsidies function similarly to taxes, affecting market participants by redistributing benefits rather than burdens. Subsidies lead to a deadweight loss due to over-trading, shifting the supply curve rightward. The price received by sellers exceeds the price paid by buyers, with benefits split based on elasticity. Inelastic demand means consumers gain more, while inelastic supply benefits producers. Understanding these dynamics is crucial for grasping market equilibrium and the implications of government interventions like subsidies on economic efficiency and consumer surplus.

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's 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 the idea of a per-unit subsidy, right? There's going to be a subsidy 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 the 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 demand or, excuse me, with taxes. And lastly, we're going to see this deadweight loss, right? With taxes, we saw a deadweight loss from undertrading; 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 that were spent on overtrading, they 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 the equilibrium. So that's how they are the same. We're also going to see that there are a couple of things that are different. First, with the subsidy, remember that 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 tax. Okay, it's going to shift to the right by the amount, excuse me, by the amount of the subsidy. Okay? And lastly, 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 star, 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 they're going to split, or excuse me, 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 here 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 the 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, 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 the top here, right? So 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 benefits. 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 star and this was our Q star 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. 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 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've got the price to the buyer, right. A lower price and then the government fills in that gap and gives the supplier is going to have more money, right? Okay. So let's go ahead and see how this one 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 are on the top part of this graph. The subsidy curve 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 are 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:

How do government subsidies affect market equilibrium?

Government subsidies affect market equilibrium by shifting the supply curve to the right, which leads to a lower price for consumers and a higher price received by producers. This results in an increase in the quantity traded beyond the equilibrium quantity, causing over-trading. The subsidy creates a deadweight loss because resources are allocated inefficiently, as they could have been used more effectively elsewhere. The benefits of the subsidy are split between consumers and producers based on the elasticity of demand and supply. Inelastic demand means consumers gain more, while inelastic supply benefits producers more.

What is the relationship between subsidies and deadweight loss?

Subsidies create a deadweight loss by causing over-trading, which means the quantity traded exceeds the equilibrium quantity. This inefficiency arises because the resources used in the subsidized market could have been better utilized in other areas. The deadweight loss represents the loss of economic efficiency when the equilibrium outcome is not achieved. In the case of subsidies, the government intervention distorts the market, leading to an allocation of resources that does not maximize total surplus.

How do price elasticities of demand and supply affect the distribution of subsidy benefits?

The distribution of subsidy benefits between consumers and producers depends on the price elasticities of demand and supply. If the demand is more inelastic, consumers will receive a larger share of the subsidy benefits because they are less responsive to price changes. Conversely, if the supply is more inelastic, producers will gain more from the subsidy. This is because the inelastic party, whether consumers or producers, is less sensitive to price changes and thus captures 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 traded. Taxes increase the price paid by consumers and decrease the price received by producers, leading to a lower quantity traded and a deadweight loss due to under-trading. Subsidies, on the other hand, decrease the price paid by consumers and increase the price received by producers, resulting in a higher quantity traded and a deadweight loss due to over-trading. In both cases, the burden or benefit is split between consumers and producers based on the elasticities of demand and supply.

Why do subsidies lead to over-trading in a market?

Subsidies lead to over-trading because they lower the effective price for consumers and raise the effective price for producers, encouraging more transactions than would occur at the equilibrium price. This increase in quantity traded surpasses the equilibrium quantity, resulting in an inefficient allocation of resources. The over-trading occurs because the subsidy artificially inflates the market activity, leading to a deadweight loss as resources are diverted from more efficient uses.