SUBSIDIES & ELASTICITY BLINK & DORTON, 2007, p64-72

What are Subsidies? A subsidy is an amount of money paid by the government to a firm, per unit of output. There are a number of reasons why a government may give a subsidy for a product.

Reasons for Subsidies 1.The lower the price of essential goods, such as milk to consumers. In this way the government hopes that consumption of the product will be increased, encouraged by lower prices.

Reasons for Subsidies 2. To guarantee the supply of the products that the government thinks are necessary for the economy. This may be because the goods are essential for the economy, such as basic food supply or a power source like coals. It may be also be that the industry creates a lot of employment that would be lost, thus creating economic and social problems.

Reasons for Subsidies 3. To enable producers to compete with overseas trade, thus protecting the home industry.

Subsidies & Supply Curves If a subsidy is granted for a certain product, then the supply curve for the product will shift vertically downwards by the amount of the subsidy, because it reduces the costs of production for the firm and more will be supplied at every price. As with indirect taxes, the amount of subsidy that is passed on to consumers and the amount retained by producers will depend on relatively elasticities.

Specific Subsidies Although percentage subsidies are sometimes granted, they are rare, so main focus is on specific subsidies. A specific subsidy is a specific amount of money that is given for each unit of the product, example, a subsidy of $2 per unit.

THE EFFECT OF A SUBSIDY ON A SUPPLY CURVE. A subsidy is given by the government of $2 per unit. It has the effect of shifting the supply curve vertically downwards by the amount of the subsidy, in this case $2, at every price level. S 1 is the original supply curve and S 1 – subsidy is the curve after the subsidy is granted.

Effect of a subsidy on Producers The market is in equilibrium with Q e being supplied and demanded at a price of P e. After the subsidy of WZ per unit is granted, the supply curve shifts vertically downwards from S 1 to S 1 – subsidy. The producers lower their prices and increase output until a new equilibrium is reached, which is at a price of P 1 where is Q1 is demanded and supplied. The price for consumers falls form P e to p 1, but not by the whole amount of the subsidy, which would need to fall to P 2. The income of the producers rise from the original amount of 0P x XQ e to 0DWQ 1.

Subsidies and their impact on Consumer Expenditure In this graph consumers get to buy the original Q e units at a lower price, P 1 thus saving the expenditure P 1 P e XY. However, they do purchase more units, Q e Q 1 because the price is lower spending Q e YZQ 1. extra. Total consumer expenditure may increase or fall, depending upon the relative savings and extra expenditure. QeQe Y

Subsidies: Cost to Government The total cost of the subsidy to government is P 1 DWZ. The money has to be found somewhere and so there is an opportunity cost here. The government must either take money away from other areas of expenditure, such as building infrastructure or it must raise taxes.

PED - ELASTIC / PES – INELASTIC Impact of Subsidy The price to consumers falls from P e to P 1 a small part of the subsidy. If the whole subsidy was passed on, price would need to fall to P 2. The income of producers rises from the original amount of 0P e XQe to 0DYQ 1. Consumption of the product is increased and so is the revenue of the producers. The consumers do not benefit from a great price fall, but because their demand is relatively elastic they increase their consumption by a significant amount.

PED = INELASTIC / PES = ELASTIC Impact on Subsidy The price to consumers falls from P e to P 1, a significant part of the subsidy. If the whole subsidy was passed on, price would fall to P2. Consumption of the product is increased and so is the revenue of the product. The consumer benefits from a relatively large price fall, but because their demand is relatively inelastic, their consumption does not increase by a great amount.

Rules relating to the granting of subsidies on producers and consumers 1. Where the value of PED is equal to the value of the PES for a product, then the price of the product will fall by half of the subsidy.

Rules relating to the granting of subsidies on producers and consumers 2. Where the value of PED is greater than the value of PES for a product, (elastic product) then the price of the product will fall by less than half of the subsidy.

Rules relating to the granting of subsidies on producers and consumers 3. Where the value of PED is less than the value of PES for a product (inelastic product) then the price of the product will fall by more than half of the subsidy.

Rules relating to the granting of subsidies on producers and consumers In all cases, consumption will rise and the income of producers will be increased.

Factors to evaluate when considering a subsidy (p70) The opportunity cost of government spending on the subsidy in terms of other alternative government spending programs Whether the subsidy will allow firms to be efficient, if they do not have to compete with foreign producers in a “free market” Although a subsidy allows consumers to buy products at a lower price, they may also be taxpayers who are funding the subsidy. Who is paying the taxes?

Factors to evaluate when considering a subsidy (p70) What damage will it do to the sales of foreign producers who are not receiving subsidies from their governments?

Key Economic Debate: Subsidies for farmers in Developed Countries There is great deal of international debate concerning the billions of dollars of subsidies that high-income countries give to their farmers. These subsidies lead to over production and it is argued that this is highly damaging to small-scale farmers in developing countries who do not receive subsidies themselves and have to compete with the low prices charged by the farmers who do not receive subsidies.

Key Economic Debate: Subsidies for farmers in Developed Countries High income country farmers are accused of dumping their products in developing countries. What is dumping? When countries or companies are accused of selling products beneath their costs of production. This is a major issue of contention at the World Trade Organization.

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Examination Questions Short Response Questions 1.Explain the effect on consumers and producers when a specific tax is placed on a product that has relatively elastic demand and relatively inelastic supply. (10 marks)

Examination Questions Short Response Questions 2. Explain the effect on consumers and producers when a government grants a subsidy to the producers of a product that has relatively elastic demand and supply. (10 marks)

Examination Questions Essay Questions 1a. Explain the possible effects of granting a subsidy to a producer (10 marks) b.Evaluate the reasons why a government might grant a subsidy to an agricultural product. (15 marks)

Examination Questions Essay Questions 2. a. Explain the possible reasons why a government might impose an indirect tax on a product (10 marks) b.Evaluate the possible outcome of imposing such a tax. (15 marks)