Subsidies: Videos & Practice Problems

Government subsidies shift the demand curve to the right, leading to a higher quantity exchanged than at equilibrium. This results in different prices for buyers and sellers: the price paid by buyers decreases, while the price received by sellers increases due to the subsidy. The benefits of the subsidy are split based on the price elasticities of demand and supply. The more inelastic party receives a greater share of the subsidy. However, this also creates a deadweight loss because resources are over-allocated to the subsidized market, which could have been used more efficiently elsewhere.

Subsidies create deadweight loss by pushing the quantity exchanged past the market equilibrium. This over-trading means that resources are being used inefficiently. The additional units produced and consumed due to the subsidy could have been allocated to other areas where they might have generated more value. This misallocation of resources results in a loss of economic efficiency, known as deadweight loss, because the cost of the subsidy exceeds the benefits derived from the additional production and consumption.

The benefits of a subsidy are split between consumers and producers based on the price elasticities of demand and supply. If the demand is more inelastic than the supply, consumers will receive a larger share of the subsidy benefit. Conversely, if the supply is more inelastic than the demand, producers will receive a larger share. This is because the more inelastic party is less responsive to price changes, allowing them to capture a greater portion of the subsidy.

Both taxes and subsidies affect market participants by altering prices and quantities exchanged. With taxes, the burden is split between consumers and producers based on price elasticities, leading to a decrease in the quantity exchanged and a deadweight loss from under-trading. Subsidies, on the other hand, provide benefits that are also split based on elasticities, but they increase the quantity exchanged, resulting in a deadweight loss from over-trading. In both cases, the more inelastic party bears more of the tax burden or receives more of the subsidy benefit.

Price elasticities determine how the benefits of a subsidy are distributed between consumers and producers. If the demand is more inelastic than the supply, consumers will receive a larger share of the subsidy benefit because they are less responsive to price changes. Conversely, if the supply is more inelastic than the demand, producers will receive a larger share. This is because the more inelastic party can capture a greater portion of the subsidy, as they are less likely to change their behavior in response to price changes.