Subsidy

A payment made to firms from the government in order to decrease the cost of production and increase supply of a good / service.

Examples

• Education
• Farming
• Free school meals
• Bike scheme
• NHS
• Public transport
• Electric cars
• Leisure centre

Positives

• If set correctly will correct market failure and create a socially optimal outcome. The market will operate efficiently.
• The third party will receive an increased benefit of consumption / production
• Products become more affordable to lower income consumers (progressive). For example, education is fully subsidised by the government
• A price incentive is more effective than other methods such as advertising

Negatives

• Subsidies are expensive
• Government failure will occur if the subsidy is set too high or low (because where to set it is based on a value judgement)
• Firms can be inefficient, as they rely on the subsidy and therefore don't seek to lower costs, since the subsidy will give them sufficient profit.
• Not all of the subsidy is passed on to consumers
• The impact of the subsidy will depend upon the elasticity of demand.

Judgements

• If PED is inelastic, the reduction in price won't make much difference in demand, and firms won't lower their prices much.

Diagrams

With a subsidy, we want to increase quantity since there is a positive externality that is unaccounted for in the price.

Positive Production

In order to correct a positive production market failure, we add a subsidy, adding a new line with the subsidy, which decreases the price and increases quantity.

Positive Consumption

A positive consumption diagram is more complicated, we can move the quantity to the correct level, but the price will not be at the socially optimal level.