Subsidies, and choosing between taxes and subsidies

Overview

Long-running subsidy shelter inefficient producers and subsidies unusually hard to withdraw once introduced.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Draw and describe in words the effect of a subsidy of £3.00 per unit in a market where equilibrium price is £12.00 and equilibrium quantity is 500 units.

   Model answer

   Price in £ goes on the vertical axis, quantity per period on the horizontal. Demand slopes down and supply slopes up, crossing at £12.00 and 500 units. The subsidy shifts supply vertically downward by £3.00 at every quantity, so the new curve is parallel to the old one with a constant £3.00 vertical gap. The new equilibrium is lower and to the right, at a price to the consumer of £9.75 and a quantity of 600 units. The producer receives £9.75 plus the £3.00 subsidy, which is £12.75 per unit.

2. 2

   A subsidy of £3.00 per unit lowers the price consumers pay from £12.00 to £9.75 and raises quantity from 500 to 600 units. Calculate the consumer gain, the producer gain and the total cost to the government.

   Model answer

   The consumer's price falls by £12.00 minus £9.75, which is £2.25 per unit, so the consumer gain is £2.25 multiplied by 600 units, which is £1,350. The producer receives £9.75 plus £3.00, which is £12.75, a rise of £0.75 on the old price of £12.00, so the producer gain is £0.75 multiplied by 600 units, which is £450. The total cost to the government is £3.00 multiplied by 600 units, which is £1,800, and £1,350 plus £450 equals £1,800.

3. 3

   Why does a subsidy of £3.00 per unit fail to cut the price consumers pay by the full £3.00?

   Model answer

   The subsidy shifts the supply curve down by £3.00, but the price consumers pay is set where that new curve meets the unchanged demand curve. The lower price causes quantity demanded to extend, and firms will only supply the extra output at a higher net price, so part of the subsidy is absorbed in the price producers receive rather than passed on. In the case above the consumer's price falls by only £2.25 while the producer's receipts rise by £0.75, and £2.25 plus £0.75 equals the £3.00 subsidy.

4. 4

   Which side of a market captures most of a subsidy, and what determines that?

   Model answer

   Whichever side is less responsive to price captures the larger share, exactly as with a tax. If demand is inelastic and supply elastic, quantity extends easily as price falls, so most of the subsidy shows up as a lower price to consumers. If supply is inelastic, extra output is hard to produce, price to the consumer falls little and most of the money is absorbed by producers as a higher net price. This matters because a subsidy intended to help buyers can be captured almost entirely by sellers in a market where supply cannot expand.

5. 5

   Analyse how a subsidy moves output towards the social optimum in a market for a good with external benefits.

   Model answer

   Marginal social benefit lies above marginal private benefit, so the free-market quantity, where private benefit meets supply, is below the optimum. A subsidy per unit lowers the marginal cost the producer must cover, shifting supply vertically downward by the amount of the subsidy. Price to the consumer falls, quantity demanded extends along the demand curve, and output rises. If the subsidy per unit equals the marginal external benefit, the new quantity is the one at which marginal social benefit equals marginal social cost, and the welfare loss from under-consumption is removed.

6. 6

   Is subsidising public bus services a good use of government money?

   Model answer

   In favour: bus travel generates external benefits by cutting congestion and emissions from cars, so the market under-provides it; subsidy keeps fares low for households without cars, which is equitable; and higher frequency attracts more passengers, reinforcing the effect. Against: the money has an opportunity cost, since it could fund health or education; some of it is captured by operators rather than passed to passengers where routes face no competition; and cheap buses do little to cut emissions if the passengers gained would have walked or cycled rather than driven. The verdict depends on how many of the extra journeys genuinely replace car trips.

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