A subsidy lowers firms' costs, so supply rises, price falls and more of the good is consumed.
A subsidy is a payment from the government to producers to lower their costs. Supply increases. On a diagram, supply shifts down by the amount of the subsidy per unit.
Price falls and quantity rises. Governments subsidise merit goods and goods with external benefits, such as public transport, vaccines or solar panels, so that more people use them.
Advantages: the good becomes cheaper and more widely used, so society gains more of the external benefits. Poorer households can afford it more easily.
Disadvantages: the subsidy is paid from taxes, so it has an opportunity cost. Firms may rely on it and become less efficient. If demand is inelastic, consumption rises only a little, and some of the money simply raises firms' profits.
- Subsidy
- Government payment to producers; supply shifts down.
- Effect
- Price falls, quantity rises.
- Opportunity cost
- The tax money could have been used elsewhere.
Worked example: Should a government subsidise vaccines?
Suppose a government pays clinics $20 for every flu vaccine they give.
- Supply shifts right, so the price patients pay falls and more people get vaccinated.
- External benefit: fewer people catch flu, so fewer sick days and less pressure on hospitals.
- Cost: the subsidy is paid from tax revenue, which could have funded something else.
- Depends on: whether price is what stops people getting vaccinated, or fear and lack of information.
Watch out for this
A subsidy is a payment to consumers, so it shifts demand.
In this syllabus a subsidy is paid to producers. It lowers their costs and shifts supply, not demand.
Check your understanding
A government gives producers a subsidy on solar panels. What happens in the market?
- Supply increases, so price falls and quantity sold rises.
- Demand decreases because the government is involved.
- Supply decreases and price rises.