A subsidy is a government payment to a firm to encourage production of a particular good.
For example the UK Government is subsidising charging port infrastructure for electric vehicles with a cost of £140 million.
Another example is the UK Government subsidises solar panels. There has been a reduction in VAT to 0% for solar panels. Also homeowners can receive grants of up to £14,000 for home improvements, including solar panels, under the ECO4 scheme.
Diagram
The diagram shows the effect of a subsidy on the market for solar panels.
This leads to a shift right in the supply curve of solar energy from S to S1. Hence a fall in price for solar energy from p to p1, and a rise in the quantity of solar energy used in equilibrium from q to q1.
The area shaded in red shows the consumer incidence of the subsidy and the area shaded in blue shows the producer incidence.
In this particular example, firms benefit more from the subsidy than the consumers. But depending on the PES and PED, the consumers can benefit more than the producers.
Solar panel prices have fallen 88% though from 2010 to the 2020s in the UK, suggesting subsidies may have contributed to decreased prices.
Also the quantity supplied has increased. As demand for labour is derived demand, it is likely that demand for workers will increase too, leading to higher employment in this industry.
Welfare effect of subsidies – no market failure
Suppose the government subsidises a market, where there is no market failure.
Then the subsidy causes a welfare loss of area BEF.
Why is the welfare loss BEF?
Before the subsidy, the consumer surplus is ABp. After the subsidy, consumer surplus (CS) increases to AFp1. Consumers consume more for a lower price. So CS rises by pBFp1.
Before the subsidy, producer surplus is pBC. After the subsidy, producer surplus (PS) increases to p2EC. The producer sells more for a higher price. Note we use the original supply curve to measure producer surplus – this makes calculating the welfare change much easier. The increase in PS is p2EBp.
Yet the government loses money from the spending on the subsidy. The total spending on the subsidy is p2EFp1.
Add up the CS gain, PS gain. Then subtract the government spending. Overall there is the welfare loss BEF.
Why is there a welfare loss? The government spending exceeds the gain in CS and PS.
When subsidies improve social welfare
Suppose there is a market failure in the market without a subsidy. Then a subsidy can improve social welfare.
Specifically, subsidies can eliminate market failures where there are positive externalities.
For example with education, the UK Government subsidises the places of home university students. Students pay tuition fees that are capped and the Government pays the remainder.
Education can have positive externalities in consumption. For example education can raise the human capital level of workers, boosting their marginal revenue product (MRP). MRP is The extra revenue a worker generates from working one more hour.
Education creates more skilled workers for firms to hire. As these workers have higher MRP, their wages rise. This creates extra tax revenue for the Government, another positive externality.
This means the marginal social benefits of education exceed the marginal private benefits at a given quantity. The subsidy decreases the marginal private cost of education provision, increasing the quantity of education produced to the allocatively efficient level at which marginal social benefit = marginal social cost, eliminating the externality and associated welfare loss.
Other effects of subsidies
Subsidies could be reinvested by the firm. For example into improving product quality or reducing future costs of production. This increases future demand from consumers for the solar panels and hence over time profit also increases. If the firm passes on cost reductions to consumers by lowering prices, then consumers experience higher consumer surplus.
Subsides may encourage firms to become dependent on the subsidy money to make a profit. This could reduce investment and innovation at the firm. If the subsidy were removed in the future, the firm may end up being less productive and fail. Extra supernormal profit which may reduce the incentive to innovate and cut costs. So the firm is more likely to become X-inefficient. Producing above its lowest average cost curve because of reduced pressure from competition. This is particularly likely to happen if the market has a high concentration ratio, for example the market is a monopoly or oligopoly.
Subsidies impact the government budget. Subsidies have an opportunity cost. Spending on a subsidy may mean forgoing spending on healthcare or raising taxes. Particularly with a high budget deficit of 5.4% of GDP for the UK Government for 2021/22. Subsidies can be large, for example the £600 million pledged to steel companies in addition to current government support in exchange for decarbonisation efforts by the firms.
Other possible points include:
- Effects on other related markets, for example the effects of subsidies on complements and substitutes.
- Effects on product quality.
- Other related issues.
Subsidies in a cost revenue diagram
The diagram shows the subsidy reducing firm costs, with marginal cost shifting down from MC1 to MC2 and average total cost shifting down from ATC to ATC1. Supernormal profits for a firm installing solar panels increase from (p1-c)q1 to (p2-c)q2.
Subsidy evaluation points
The success of a subsidy depends on:
- Price elasticity of demand (PED). Given the demand for solar energy is likely to be price-elastic, as there are lots of substitutes for methods to acquire energy, the firm is likely to receive the greater incidence from the subsidy compared to the consumer. This means producer surplus increases significantly from the subsidy whereas consumer surplus increases only marginally. [Note the price elasticity of supply also matters].
- How the firm allocates the subsidy money. Whether the subsidy goes to reinvestment or the CEO’s pay packet and shareholder dividends matters. Reinvestment reduces costs or improves quality of the product, benefitting consumers. If the subsidy goes to dividends, then it is not helping consumers.
- Whether the Government can estimate correctly the size of the externality / market failure. In practice, estimating the size of the externality may be difficult – in this case it requires information on the effect of extra education on productivity and wages. In education for example, education may not raise human capital and worker productivity but only “signal” underlying ability according to the signalling theory. In this case the externalities would be less significant.
- The size of the budget deficit. If the budget deficit is large, debt is rising more quickly. So debt interest payments will be higher. This may make the government more reluctant to spend on the subsidy, as it will further increase the budget deficit, debt and borrowing.
- The return to the Government from the subsidy. Governments may gain higher future tax revenue from more production. So the budgetary impact may be reduced over the longer term.
- Extent of market power may influence the degree to which the subsidy is passed on to consumers.
- The design of the subsidy. Does the subsidy target particular firms? In this case, it may cause unfair advantages / an uneven playing field in the market, distorting competition. Or does the subsidy come with conditions about how to use the subsidy or not? Conditions may encourage firms to allocate subsidies towards productive uses (investment) rather than going to shareholders.
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