Subsidy
What is Subsidy?
A subsidy is a government payment to producers to lower production costs and encourage output.
Governments use subsidies to support industries they consider important, such as agriculture or renewable energy. By lowering costs, subsidies allow producers to increase output and offer goods at lower prices. However, subsidies can lead to market inefficiencies and overproduction.
Subsidy: a worked example
A government pays producers a $10 per unit subsidy on solar panels. Demand is Qd = 100 - 2P and supply before the subsidy is Qs = 3P - 50, with P in dollars and Q in thousands of panels. Setting them equal, 100 - 2P = 3P - 50 gives 150 = 5P, so P = $30 and Q = 40. The subsidy means sellers need $10 less from buyers to offer any given quantity, so supply becomes Qs = 3(P + 10) - 50 = 3P - 20. Equating again, 100 - 2P = 3P - 20 gives 120 = 5P, so buyers pay $24 while sellers receive $24 + $10 = $34, and quantity rises to 100 - 2(24) = 52. Buyers captured $6 of the subsidy and sellers captured $4. The program costs $10 x 52 = $520 thousand.
The mistake students make with subsidy
The near universal error is assuming the price buyers pay drops by the full subsidy, so a $10 subsidy is expected to cut the price by $10. The split depends on relative elasticities, and the more inelastic side captures the larger share. In the example above buyers took $6 and sellers took $4 because demand was less elastic than supply at that point. A second error is drawing a producer subsidy as a demand shift. Shift supply instead, read the buyer price off the demand curve, then add the subsidy to get the seller price.
Subsidy questions
Who gains more from a subsidy, buyers or sellers?
The more inelastic side of the market captures the larger share of a per unit subsidy. When demand is relatively inelastic, most of the benefit shows up as a lower price for buyers. When supply is relatively inelastic, most of it lands in the price sellers receive. The two gains always add up to the full subsidy per unit, so checking that they sum correctly is a quick test of your work.
Does a subsidy shift supply or demand?
A per unit subsidy paid to producers shifts the supply curve down by the subsidy amount measured vertically, which is the same as shifting it to the right. Sellers now need less money from buyers to cover any given unit. A subsidy paid to consumers instead shifts demand up by the subsidy amount. Either version produces the same equilibrium quantity and the same split of the benefit.
Why does a subsidy cause deadweight loss?
Subsidies push output past the efficient quantity. Beyond equilibrium, the cost of producing another unit exceeds what buyers value that unit at, so each extra unit destroys a little surplus even though the payment makes it privately worthwhile. The loss is the triangle between the supply and demand curves running from the original quantity to the subsidized quantity. The exception is a good with a positive externality, where a subsidy can correct underproduction.
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Related terms
Common comparisons
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