Subsidy

Let's use the same approach to analyze the effect of a subsidy.

Subsidy: A subsidy is a payment from the government to a firm or individual in the private sector, usually on the condition that the person or firm that receives the subsidy produce or do something, or to increase the income of a poor person.

For our example, we will think of a subsidy for the production of corn. (Some countries have paid subsidies for the production of grain in order to make food cheaper for poor people). Let us suppose the government pays corn farmers a dollar per bushel of corn, in addition to whatever price they get in the marketplace. Figure 11 shows the supply and demand for corn. A subsidy per unit of production works pretty much like an excise tax, except in reverse. In particular, we can look at the change from the point of view either of buyers or sellers. In this example, we will look at the subsidy from the point of view of the buyers. From their point of view, the subsidy is an increase in supply.

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Figure 11. A Subsidy

Accordingly, the figure shows the subsidy shifting the supply curve to the right, from S₁ to S₂. The vertical distance is the amount of the subsidy: one dollar per bushel. Demand is D, as usual. With supply S₁ -- before the subsidy is given -- the market equilibrium price is p₁ and the equilibrium production is Q₁. With supply S₂ -- when the subsidy is given -- the market equilibrium price is p₂ and the equilibrium production is Q₂. We may conclude that a subsidy per unit of production reduces the market price (though not quite by the full amount of the subsidy) and increases the production of the item subsidized.

Chapter Summary