What is Subsidy? – Explained!

A subsidy is a form of payment from the government to the producers to boost the production in agriculture sector or other priority areas. The benefits conferred to the producers are transferred to the buyers either fully or partially depending upon the elasticity of demand and elasticity of supply. Since subsidy can be considered as a negative tax it shifts the supply curve downward.

Fig. 10.22 shows the pre-subsidy equilibrium at point ‘E’ where the demand curve DD and supply curve SS intersect each other. The equilibrium price is OP and the equilibrium quantity is OQ. Now, suppose a per unit subsidy equal to EF is granted to the producer. This subsidy will help in reducing the cost of production of the producers.

As a result, the supply curve shifts downward to S₁S₁. The new equilibrium is at point E₁, where the new supply curves S₁S₁ and the demand curve DD intersects each other. OP and OQ are the new equilibrium price and equilibrium quantity respectively.

Image Source: i.ytimg.com

It is clear from the figure that as a result of the subsidy, the price comes down by PP, or EA and the quantity rises by QQ, Consumers benefit EA per unit, i.e., equal to fall in the price per unit. The producers will receive benefit equal to AF per unit. It can be easily shown that

Consumer Benefit/ Producer Benefit = EA/ AF = E_s/ E_D

Total consumer benefit equals P₁PEA and total producer benefit equal BP₁AF. The total subsidy paid by the government is equal to the sum of total benefits of consumers (or buyers) and producers (or sellers).

Like the case of taxation, it can be shown that

(i) Given elasticity of demand, as the elasticity of supply increases, consumer benefit increases, while producer benefit decreases and vice-versa.

(ii) Given elasticity of supply, as the elasticity of demand increases, consumer benefit falls, while producer benefit increases and vice-versa.

(iii) The benefit of the subsidy is equally shared by the consumers and producers, when the elasticity of supply equals the elasticity of demand.

(iv) When elasticity of demand is equal to infinity (perfectly elastic demand), producer’s comer the entire benefit and consumer benefit of the subsidy becomes equal to zero. Opposite will be the situation when the elasticity of demand is equal to zero (perfectly inelastic demand).

(v) When the elasticity of supply is equal to infinity (perfectly elastic supply), consumer’s corner the entire benefit and producer benefit of the subsidy becomes equal to zero. Opposite will be the situation, when the elasticity of supply is equal to zero (perfectly inelastic supply).

In exceptional situation, when the supply curve slopes downward, consumers corner more than hundred percent of the benefit, as illustrated in Fig. 10.23. In this figure, the per unit subsidy of EF shifts the supply curve downward from SS to S₁S₁.

The equilibrium point given by the inter-section of the supply and the demand (DD) curves changes from point ‘E’ to point ‘F’. The price falls by PP, (from OP to OP₁) or EA, which is greater than the per unit subsidy of EF. Hence, consumers are in a position to corner more than hundred percent of the benefit, when the supply curve slopes downward. The total consumer benefit is equal to the product of PP₁ (benefit per unit) and OQ, or P₁ E₁ (new equilibrium quantity).

Fig. 10.23: Effect of Per Unit Subsidy (When Supply Curve Slopes Downward)