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The impact of subsidies

A subsidy is a payment made to firms or consumers designed to encourage an increase in output. A subsidy will shift the supply curve to the right and therefore lower the equilibrium price in a market.

The aim of the subsidy is to encourage production of the good and it has the effect of shifting the supply curve to the right (shifting it vertically downwards by the amount of the subsidy). This is shown in Figure 1 below.

Figure 1 Impact of a subsidy

The amount of the subsidy is shown by the gap between the supply curves. This subsidy will cost the government money and we can use the diagram to show the amount they have to spend. Total subsidy expenditure will be the subsidy per unit (the vertical gap between the supply curves) multiplied by the number of units that are traded on the market. This gives the area shown in Figure 2 below.

Figure 2 Subsidy expenditure

As with a tax (see the previous section - click on the left arrow at the top or bottom of the page), some of the subsidy will benefit the consumer (the amount of the price decrease) and some will benefit the firm. This effect can be seen in Figure 3 below.

Figure 3 Subsidy shares - producer and consumer