Subsidies
Subsidies given to consumers
P
S
P1
P0
P2
A
B
C
D
E
subsidy
D
0
D1
Q
Q0
Q1
When a subsidy is given to consumers, it increase consumers’ willingness to pay for the good by the size of
subsidy—i.e. the demand curve shifts up by the amount of the subsidy. This increase in demand drives up the
price of the good in question to P1 and the quantity sold to Q1. While the good itself costs P1, the consumer then
gets a subsidy which lowers the cost of the good to them. The actual cost to consumers is P1-subisdy= P2.
Both consumers and suppliers are made off by the subsidy. Since suppliers collect a higher price (P1) and sell
more goods (Q1), their producer surplus increases by A + B. Since consumers buy more goods (Q1) at a lower
final price (P2, after taking the subsidy into account), consumer surplus increase by C+D. The government has to
pay for the subsidy, so government expenditures are subsidy*Q1 = A+B+C+D+E. Of the government’s
expenditures (A+B+C+D+E), A+B is a transfer to suppliers in the form of higher producer surplus and C+D is a
transfer to consumers in the form of higher consumer surplus. That leaves E, which is the deadweight loss
caused by the subsidy. Think of this deadweight loss as inefficiency since for all the goods between Q0 and Q1,
consumers are buying goods they value less than the suppliers cost of providing them. These goods are only
bought because the subsidy creates a wedge between what consumers have to pay for a good versus what
suppliers are paid for their good.
While in the diagram above consumers and suppliers benefitted equally from the subsidy, the actual share of
who gains more depends on which side is more inelastic. The side that is more inelastic (or less elastic) will
receive a large portion of the subsidy (and if one side is perfectly inelastic it will receive the entire subsidy).
Intuitively, if suppliers are more elastic, then the quantity supplied will increase considerably to meet the higher
demand and thus the price will not increase much. They will benefit from a slightly higher price, but they do not
benefit by as much as consumers, for whom the price is much lower after the subsidy is taken into account. On
the other hand, if supply is more inelastic, then the quantity supplied won’t increase much in response to the
increased demand, meaning prices will increase considerably. The suppliers benefit from the higher price, more
so than consumers do, since the price consumers pay after the subsidy will only be slightly lower.
Subsidies given to suppliers
P
S0
S1
subsidy
P2
P0
A
B
P1
C
D
E
D0
Q
Q0
Q1
When a subsidy is given to suppliers, it decreases the amount suppliers require as payment for their goods by
the amount of the subsidy since they will get the subsidy in addition to what consumers pay them for the goods
themselves. This means the supply increases as the supply shifts down by the amount of the subsidy. The
increase in supply decreases the price to P1 and increases the quantity to Q1. While the suppliers receive a lower
price (P1) for their goods, they also receive the subsidy, so the final amount they receive for their goods is
P1+subsidy=P2.
Everything else is the same as above. Since suppliers collect a higher final price (P2, once the subsidy is
considered) and sell more goods (Q1), their producer surplus increases by A + B. Since consumers buy more
goods (Q1) at a lower price (P1), consumer surplus increase by C+D. The government has to pay for the subsidy,
so government expenditures are subsidy*Q1 = A+B+C+D+E. Of the government’s expenditures (A+B+C+D+E),
A+B is a transfer to suppliers in the form of higher producer surplus and C+D is a transfer to consumers in the
form of higher consumer surplus. That leaves E, which is the deadweight loss caused by the subsidy. Think of
this deadweight loss as inefficiency since for all the goods between Q0 and Q1, consumers are buying goods they
value less than the suppliers cost of providing them. These goods are only bought because the subsidy creates a
wedge between what consumers have to pay for a good versus what suppliers are paid for their good.
Again, the side that is more inelastic (or less elastic) will receive a large portion of the subsidy (and if one side is
perfectly inelastic it will receive the entire subsidy). Intuitively, if demand is more elastic, then the quantity
demanded will increase considerably to meet the higher supply and thus the price will not decrease much.
Consumers will benefit from a slightly lower price, but they do not benefit by as much as suppliers, for whom
the price is much higher after the subsidy is taken into account. On the other hand, if demand is more inelastic,
then the quantity demanded won’t increase much in response to the increased supply, meaning prices will
decrease considerably. The consumers benefit from the lower price, more so than suppliers do, since the price
suppliers receive after the subsidy will only be slightly higher.