Subsidies

A subsidy is a grant, usually provided by the government, to encourage suppliers to increase production of a good or service, leading to a fall in price. Bus and train companies are often given subsidies in order to increase the number of their respective services, which benefits both the firms and the consumers.

A subsidy is often paid directly to producers but as they respond by increasing output, the market price falls and this indirectly passes on some of the gain to consumers. If demand is price inelastic, then the market price falls by a relatively large amount, increasing the benefit to consumers. If demand is price elastic, then market price falls by a relatively small amount and so there is less gain for consumers. The diagram below shows the impositions of a government subsidy for a good.

Before the subsidy, equilibrium rice is Pe and Qe. After the subsidy is imposed, the supply cive shifts to S2 and equilibrium price falls to P2 while the quantity rises to Q2. To total subsidy area is RLGP2.

The amount of subsidy that consumers gain is shown by the actual fall in market price from Pe to P2. They gain by paying a lower price for the good. THe consumer subsidy area is RTPeP2. THe remaining subsidy area od TLGPe represents the gain made by the producers.

[diagram on page 34]

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