Appl Ex 9b

Application Exercise 9b: Subsidies designed to reallocate resources

  1. A producer subsidy is a payment made by the government to the producer to offset production costs of specific items or production generally. For example, to produce electric vehicles or to employ young people (who generally have a higher unemployment rate due to lack of experience).  A consumer subsidy is a payment by the government to a consumer or household to offset the cost of a purchase. For example, a childcare subsidy pays a portion of the cost of childcare to make child care more affordable and enable parents to work, which contributes to economic activity.


  1. A consumer subsidy is likely to shift the demand curve to the right, resulting in a higher equilibrium price and equilibrium quantity traded.


  1. A producer subsidy is likely to shift the supply curve to the right as the offset to production costs makes producers more willing and able to supply. This results in lower equilibrium price and a higher equilibrium quantity traded.


  1. Through higher demand for a product with a consumer subsidy (refer to question 2 response), there will be a higher equilibrium quantity traded. This means that consumers will be demanding more, and producers will be supplying more in response. The price increases ‘in response to’ the higher demand, which is why there is more consumption and production of the product even though the market price has increased.


  1. Subsidies are generally provided to producers with positive externalities, or to achieve an economic or social objective. For example, childcare subsidies enable more people to participate in the workforce and therefore improve a nation’s technical efficiency and ultimately economic growth. For a product with positive externalities, it enables more of the product to be consumed and produced than otherwise would occur in the absence of the subsidy.  To the extent that there was an underallocation of resources to the production of the product in the past (i.e. to the left of the equilibrium quantity in the diagram before the subsidy is introduced) , the subsidy helps to ensure that a more socially optimal allocation of resources (or socially optimal level of production) takes place (with equilibrium occurring to the right of the market equilibrium pre-subsidy).  This will improve the collective satisfaction of individuals and therefore improve allocative efficiency – that is, the highest level of satisfaction achieved from society’s scarce resources.