Hi everybody! Subsidies are a moneygram given to firms by the government to reduce their cost of production and to encourage an increase in output. Subsidies and microeconomics are a form of government intervention but always for two core reasons. First of all to solve market failures, that is to encourage more consumption and more production of goods and services that are beneficial to the whole of society. So governments around the world often will subsidize vaccinations, healthcare, education more widely.
They'll subsidise public transportation like trains and buses. They'll subsidise energy efficient boilers, home insulation, electric cars, even in-work training programmes and research and development that firms engage in often will receive subsidies all for this core purpose to encourage more consumption and more production of those goods and services. But equally governments out there will use subsidies to encourage greater affordability of necessity goods and services. Subsidies reduce the price in the market and that can be very helpful.
for low-income households to access the market, to be able to afford essential goods and services. So that's another core reason why subsidies are used. But in this video, let's go into detail and understand what the key impacts of a subsidy are diagrammatically. Well, let's take this market here at equilibrium of P1 and Q1, and let's apply a subsidy.
Well, we know from prior videos that a subsidy will reduce cost of production for firms, and thus will shift the supply curve to the right. But being more hyper-technical, a bit like an indirect tax, we can say here for a subsidy that a subsidy will shift the supply curve downwards and that is because the vertical distance between the two supply curves is always the value of the subsidy per unit. So let's add that on to our diagram.
So yeah, when we talk about the shift it's okay to say it shifts to the right but really we should say it shifts downwards from S1 to S1 plus sub. And that means we get a new equilibrium at P2 and Q2. And what we can see very clearly is how a subsidy reduces price in the market and increases quantity, doing exactly what we want it to do in terms of what the government aims are.
So let's write that down. Price reduces from P1 to P2 and the quantity in the market increases from Q1 to Q2. Great.
But that's very basic stuff. We know that already from prior videos. Let's go into more detail now. we can actually work out the overall cost to the government of a subsidy.
And the way we do that is exactly the same way in which we work out the government revenue in their tax. So what we do is we go to the new equilibrium, P2Q2 point B here. At point B, we work out the vertical distance between the two supply curves.
Let's do that together. So if we go up, let's call this point point C. That vertical distance, BC, is the value of the subsidy per unit. What we now need to do is multiply that by all the units up to Q2, because they're all the units being produced and sold.
They're all the units getting the subsidy. So BC multiplied by Q2 gives us this area. The area P2, B, C, D, and that represents the overall cost of the government.
B2, B, C, D. I'll go through that again. So we go to the new equilibrium, which is B, P2, Q2, work out the vertical distance between the two supply curves. BC is the subsidy per unit multiplied by Q2. It gives you that area, the overall cost of the government.
Fantastic. We can now also work out the producer revenue. Remember revenue? It's just price times quantity. So before the subsidy, producers were charging P1 and selling Q1.
So P1 times Q1, P1, A, Q1, 0. What is it now with the subsidy? Well, you might be thinking, oh, they're now charging P2 and they're selling Q2. So P2 times Q2, right?
Not quite. That is the revenue coming from consumers, correct? But remember, the subsidy is going to producers.
So that box of government cost ends up also being producer revenue. So in truth, the producer revenue has increased massively to now DCQ20. So we can see it's increased from P1AQ10 to this huge box of DCQ20.
No wonder producers love subsidies, right? Massive increase in their revenue. Happy days if you're a producer.
Let it come in, rake it in if you're a producer. Okay, we can see that clearly from the diagram, but also consumers are winning to an extent. There are some consumer savings taking place. How do we work that out?
Well, before the subsidy, consumers were buying Q1 at the price of P1, whereas now because the subsidies reduce the price, consumers can buy Q1 at a lower price of P2. So if I add the label E, Over there, the entire consumer savings can be shown by the area P1, P2, AE. buying the same quantities before but now at a lower price consumer savings.
But by intervening here the government putting a lot of taxpayers money into this market, subsidizing whatever this good or service is, creates a deadweight welfare loss and that is the triangle A, B, C. If you guys click on this link over here you'll see a video where I explain why a subsidy creates a deadweight loss and what the implications are. Be sure to watch that. But they are the key impacts. Let's now go to how stakeholders feel about subsidies. Well, it's clear from the diagram that consumers do like subsidies to an extent because prices fall, consumer surplus goes up, there's higher quantity, there's higher choice in the market.
Also, if you're a low-income household, greater affordability of necessity goods and services, that could be very important to you. At the same time, we've also mentioned the consumer savings that take place. But the issue for consumers is really how this subsidy is going to be funded over time. Is it going to mean tax rises that hurt consumers?
Is it going to mean cuts? to other areas of government spending in the economy which can hurt consumers? Is the government going to borrow money which means debt interest needs to be paid, an opportunity cost of that money? And generally the opportunity cost attached to a subsidy, is that really the best use of public money? So yes we can say consumers benefit but there are long-run concerns for them.
Producers and workers definitely love subsidies. I mean producers, oh yes please, I mean we can see why. Huge increase in producer revenue is the main thing, and also a big increase in producer surplus. You will not find producers out there who argue against subsidies.
They love them. And even workers, because of higher quantity, we know labor is a derived demand, there could be greater employment here, which is good for workers. In theory, we can say, yeah, governments will like subsidies if their two main aims are being achieved, if they're solving market failures, if they're encouraging greater affordability and helping out low-income households, of course.
Right, governments will be happy if that's taking place, but governments will be mindful of how expensive the subsidy is, all the arguments we just said, you know, the opportunity cost, the long run funding concerns. Governments will also be concerned as to how subsidies are being used. So are producers taking advantage of subsidies and maybe doing other things with that money? For example, paying off debts or saving at a bank or paying higher dividends to shareholders, paying bonuses or higher salaries to their staff?
And also long run, do producers become dependent on subsidies? that they become complacent and inefficient, allowing other costs of production to rise, knowing they're getting this free money from the government. So the government will be mindful of that and, of course, of the deadweight loss that they are creating here. So this video covers all the major impacts of a subsidy diagrammatically. You really get into how a subsidy works.
So thank you very much for watching, guys. I will see you all in the next video, where we start looking at price controls, minimum prices. See you then.
Thank you.