Top 3 Misconceptions about Subsidies

Welcome back to our lost and found series where we cover the misconceptions that we as students faced and help them get back on the right track!

This week, we will be looking at Subsidies!

1. Subsidies do not just refer to direct payments by governments!

It can also include other forms of assistance such as interest-free loans. However, based on the IB curriculum, we will only be looking at cash payments. 

An approved definition of subsidy is: Payments by governments to firms to lower costs and prices

2. How much consumers pay and how much producers receive after the subsidy is implemented.

Some students forget that the price that consumers pay and producers receive is not the same when a subsidy is implemented.

This is contrasted to when there is no government intervention and the market is left to its own to form the equilibrium price and quantity. Then, in this case, price consumers pay and the price producers receive is the same. 

So, how does the price consumers pay and price producers receive differ? 

As shown in the diagram above, PeQe represents the equilibrium Price and Quantity which is established by the free market (Intersection of D and S). However, when the subsidy is implemented, the Supply curve shifts to the right as producers receive more (Pp) and consumers pay less(Pc). 

The difference between Pp and Pc is the subsidy per unit. 

3. When a subsidy can lead to society being worse off.

But that doesn’t make sense right? After all, isn’t a subsidy supposed to be a “good thing”? Doesn’t it help to encourage consumption of merit goods and even help correct positive externalities? 

This depends on the initial state of the economy. 

If the economy was in a state whereby allocative efficiency, Q>Qopt, was already achieved, then introducing a subsidy will lead to overallocation of resources, thus making society worse off. 

On the other hand, if there was a positive externality of consumption, whereby there was underallocation, then a subsidy can increase and improve the allocation of resources such that Q = Qopt.