Subsidies (Cambridge (CIE) A Level Economics): Revision Note

Subsidies

• A subsidy is a payment made by the government to producers to reduce the cost of production

• Governments frequently use subsidies to encourage production or consumption of merit goods such as energy-efficient products, electric vehicles, healthcare, and education

Diagram analysis

• The free-market equilibrium is at P_eQ_e - where MPB = MSC

  • Market failure exists as MSB > MSC at the free market equilibrium, meaning the good is under-consumed

  • Optimum level of output is at Q_opt

• A subsidy shifts the supply curve right from S → S₁

  • It does not completely eradicate the potential welfare gain but moves the market closer to the optimum level of output (Q_opt)

  • The potential welfare gain has been reduced as shown in the diagram

    • This represents a reduction in deadweight loss and an improvement in allocative efficiency

• The new market equilibrium is at P₁Q₁

  • This is a lower price and higher output

  • There is less under-consumption and so less market failure

  • Some of the external benefits available have been realised

Subsidy incidence

• The incidence (share) of the subsidy is determined by the PED of the product

  • If governments subsidise goods or services with high PED, the increase in QD will be more than proportional to the decrease in price 

  • Producers keep some of the subsidy and pass the rest on to the consumers

Diagram analysis

• The original equilibrium is at P₁Q₁

• The subsidy shifts the supply curve from S → S + subsidy:

  • This increases the QD in the market from Q₁→Q₂

  • The new market equilibrium is P₂Q₂

  • This is a lower price and higher QD in the market

• Producers receive P₂ from the consumer PLUS the subsidy per unit from the government 

  • Producer revenue is therefore P₃ x Q₂

  • Producer incidence of the subsidy is marked B in the diagram

• The subsidy decreases the price that consumers pay from P₁ → P₂

  • Consumer incidence of the subsidy is marked A in the diagram

• The total cost to the government of the subsidy is (P₃ - P₂) x Q₂ represented by area A+B

  • This creates an opportunity cost, as government funds could be used for alternative purposes

The effectiveness of subsidies

• Estimating the appropriate size of a subsidy can be difficult

• Many subsidies are applied uniformly, meaning they are not linked to consumers’ income levels or ability to pay. Unlike income-based taxes or benefits, subsidies usually reduce the price by the same amount for all users

• As a result, both higher-income and lower-income consumers benefit equally per unit consumed, even though the policy may be intended to support those on lower incomes

  • This makes it important to consider who actually gains from a subsidy

Examples

1. Domestic energy subsidies

• In some countries, governments subsidise electricity or gas to keep household energy bills affordable

• While this can help low-income households cope with rising living costs, wealthier households also benefit, often to a greater extent because they consume more energy

• In addition, lower prices may increase demand, leading to supply pressures or higher government spending.

• If subsidies are paid directly to energy suppliers, there is no guarantee that firms will become more efficient or invest in cleaner technologies

2. Subsidies for education and training

• Governments often subsidise further education or vocational training to improve workforce skills and productivity

• These subsidies can increase access to education and benefit society through higher employment and economic growth

• However, some of the financial benefits may go to individuals who could afford training without support, raising questions about whether the subsidy is well targeted

Taxes vs Subsidies (Comparison)

• Taxes discourage consumption and production, while subsidies encourage them