Just as we have seen that the imposition of a sales tax impacts on the market equilibrium for a good or service, a subsidy on a product will do the same - as the first video on this page describes, a subsidy is effectively a reverse tax on a product. Again start with the same exercise where students list those items which their government currently subsidises and then suggest possible reasons why that subsidy is put in place?
The main aim of this lesson is for your students to really question why it is that governments subsidise certain goods and services and not others? How many of those subsidised goods can really be called 'merit goods' and hence benefit the citizens of that country?
What are subsidies and what are the consequences of a government decision to place a subsidy on a good or service.
Lesson time: 80 minutes
Explain why governments provide subsidies, and describe examples of subsidies.
Draw a diagram to show a subsidy, and analyse the impacts of a subsidy on market outcomes.
Discuss the consequences of providing a subsidy on the stakeholders in a market, including consumers, producers and the government.
Plot demand and supply curves for a product from linear functions and then illustrate and/or calculate the effects of the provision of a subsidy on the market (on price, quantity, consumer expenditure, producer revenue, government expenditure, consumer surplus and producer surplus). (HL only).
Start by watching the following video, which explains the term subsidy and then answer the question which follows, before reading the class handout.
Which goods and services are subsidised by your government? Why does the government choose to subsidise those products? Consider the political as well as social and economic reasons.
Subsidy - can be defined as support provided by the government, to encourage the production or consumption of a good or service.
Merit goods - goods or services which consumers will often undervalue but which governments believe provide positive externalities.
Opportunity cost - the cost of the subsidy in terms of the alternative opportunities foregone. Examples might include higher taxes or cuts to public spending elsewhere.
Government grants - a form of government subsidy provided to help new or struggling businesses, especially those in strategically important sectors such as bio-tech.
Guaranteed minimum payment - a type of subsidy guaranteeing a minimum price for a product, such as the one offered by many governments to farmers so that production levels are guaranteed.
Bail-outs - specific help provided to key industries when struggling financially e.g. the assistance provided to financial institutions and GM in the wake of the 2008 financial crisis.
Financial assistance - a type of government assistance paid in the form of a grant or loan to encourage businesses to set up in areas of high unemployment.
The activities on this page are available as a handout at: Subsidy
The diagram to the right represents the market for good X, a merit good.
(a) Indicate the original (without the subsidy) equilibrium price and output.
(b) Complete the sentence by filling in the missing words:
Consumers benefit from a subsidy through lower prices, while producers benefit from higher revenue. The proportion of the payment enjoyed by both depends on the relative _____ and _____ of the product.
(c) Highlight from the diagram the following:
i. The increase in quantity demanded for the product
ii. The new equilibrium price and output
iii. The new price paid by the consumer and the government
iv. The size of the subsidy
vi. The increase in revenue enjoyed by the producer.
The diagram to the left represents the market for good X. The government then decides to intervene in the market for this product by providing a subsidy.
(a) Illustrate the impact of a flat rate subsidy on the market for this product.
(b) What is the new equilibrium level of output and price after the subsidy.
(c) Indicate the size of the subsidy and the total payment made to the industry.
(d) How much does producer revenue increase by?
(e) Indicate the price of the good if the selling price had fallen by the whole value of the subsidy.
The impact of PED on a market subsidy
(a) The diagram to the right illustrates the market for a PED elastic product, renewable energy. Illustrate the impact on equilibrium price and output, following the application of a subsidy on the good.
(b) Following the subsidy which variable would we expect to see the largest change - quantity demanded or selling price?
(c) The next diagram illustrates the market for children's shoes, a PED inelastic good. Illustrate the impact on equilibrium price and output, following the application of a subsidy on the product.
(d) Describe the impact on both sales and price when a subsidy is applied to a PED inelastic good.
Activity 4 (HL only)
The demand and supply for domestic electricity consumption is identified on the following table:
Price (kw) $
(a) Illustrate the above information on the following graph paper, highlighting the size of the subsidy provided by the government.
(b) Calculate the cost of the subsidy to the government.
(c) Outline the opportunity cost of the subsidy.
(d) Explain why the government may have chosen to provide the subsidy on electricity.
Activity 5: G20 governments still propping up fossil fuel exploration
In 2009, the G20 pledged to phase out 'inefficient' fossil fuel subsidies, yet research discovered that governments are still spending $88 billion every year supporting exploration – more than double what the oil and gas companies are investing. A breakdown of subsidy by country is illustrated below:
|Country||Size of subsidy in US$ per capita|
(a) Consider the data represented in the table which illustrates the level of fossil fuel subsidy paid by G20 countries and illustrate the effect of the subsidy on both fossil fuels and firms producing alternative / renewable energy sources.
(b) State whether you believe that the OEDC nations should be subsidising fossil fuels?
When a government places a subsidy on a product both the producer and consumer benefits. However, there are losers in terms of opportunity cost. Governments can either reduce spending elsewhere or raise taxes.
Watch the short video on bread subsidies in Egypt and then answer the following questions:
(a) Outline the arguments for and against the Egyptian government providing a subsidy for bread?
(b) Is there a danger that simply subsidising a product encourages firms to be inefficient? What damage might be done to firms who are not receiving the subsidy?
Activity 7: reflection exercise
Divide the class into two groups.
One group should spend 10 minutes compiling a list of some of the reasons that governments provide subsidies. The second group can then compile a similar list, detailing some of the arguments against government subsidies. Afterwards compare the two lists and decide overall whether or not governments are correct to implement a subsidy on certain products or not?
The reasons why a government will provide a subsidy to firms should include:
Arguments against subsidies
Activity 9: Link to theory of knowledge
Look again at the list of goods and services which your government subsidises and ask the question: ‘How many of those subsidised goods can really be called 'merit goods' and hence benefit the citizens of that country?'
Activity 10: Reflective activity - link to the assessment
Typical paper one questions on this topic include:
Illustrate using an appropriate diagram how a subsidy can increase the number of students applying to university. [10 marks]
Using real life examples, evaluate the effectiveness of subsidies in encouraging the consumption of education and health services? [15 marks]
Relevant questions from the paper three exam might include illustrating the impact of an indirect tax on a good or service, using a given set of data. Paper three questions on this topic might also require candidates to calculate the change in price / quantity demanded or the size of the consumer and producer surplus, after the provision of a government subsidy.