subsidies

Government Policies to Achieve Efficient Resource Allocation – Subsidies

1. Definition

A subsidy is a payment made by the government to producers, consumers or to a specific activity. Its purpose is to alter market outcomes so that the equilibrium moves closer to the socially optimal level. Subsidies are mainly used to correct market failures (especially positive externalities) and to achieve broader objectives such as equity, employment, strategic development or macro‑economic stability.

2. Objectives of Subsidies (Cambridge Syllabus 3.2 & 8.1)

• Increase the supply or consumption of goods that generate positive externalities (e.g. education, vaccinations, renewable energy).
• Lower the price paid by consumers for socially beneficial goods, thereby expanding access.
• Encourage research, development and innovation where spill‑over effects are large.
• Support industries that are strategically important or that suffer from temporary decline.
• Redistribute income by targeting low‑income households or disadvantaged regions.

3. Economic Mechanism & Incidence of a Subsidy

3.1 Basic supply‑and‑demand effect

In a market with demand curve D and supply curve S, a per‑unit subsidy s paid to producers shifts the supply curve downwards (or to the right) by exactly s.

\(Q_s = f(P + s)\)

Resulting equilibrium:

• Consumer price falls from P₁ to P_c.
• Producer receives P_p = P_c + s.
• Quantity rises from Q₁ to Q₂.

3.2 Incidence – role of price‑elasticities (Syllabus 3.2)

The split of the subsidy between consumers and producers depends on the relative elasticities of demand (\(\varepsilon_D\)) and supply (\(\varepsilon_S\)).

\(\displaystyle \Delta P = s \times \frac{|\varepsilon_S|}{|\varepsilon_S|+|\varepsilon_D|}\)

• If demand is relatively inelastic (\(|\varepsilon_D| < |\varepsilon_S|\)), consumers bear a larger share – the consumer price falls only a little.
• If supply is relatively inelastic, producers retain most of the subsidy – the consumer price falls a lot.

Worked numerical example

Incidence on consumers:

\(\displaystyle \Delta P = 2 \times \frac{1.5}{1.5+0.5}= 2 \times \frac{1.5}{2}= £1.50\)

Therefore:

• Consumer price falls by £1.50 (from £10 to £8.50).
• Producer receives £8.50 + £2 = £10.50, i.e. a £0.50 gain per unit.
• Government outlay = £2 × Q₂ (where Q₂ is the new quantity).

Diagram (producer‑side incidence)

4. Types of Subsidies (Cambridge Syllabus 8.1)

1. Production subsidies – paid per unit produced (e.g., agricultural grants, renewable‑energy feed‑in tariffs).
2. Consumption subsidies – reduce the price paid by consumers (e.g., subsidised school meals, public‑transport fare reductions).
3. Export subsidies – compensate exporters for the higher cost of selling abroad (e.g., aircraft export rebates).
4. R&D subsidies – tax credits or cash grants for research and innovation (e.g., biotech R&D tax relief).
5. Targeted subsidies – aimed at specific groups or regions (e.g., low‑income household energy vouchers).

5. Other Government Instruments for Correcting Market Failure (Syllabus 8.1)

Cambridge expects you to know the full range of micro‑intervention tools. Subsidies are only one option; the choice depends on the nature of the failure, administrative feasibility and distributional impact.

6. Advantages of Subsidies

7. Disadvantages and Potential Problems (Government Failure – Syllabus 8.1)

• Fiscal cost – The outlay must be financed, potentially increasing budget deficits or requiring higher taxes.
• Risk of over‑production – An excessively large subsidy may create a surplus, leading to waste or costly storage.
• Distortion of market signals – Firms may rely on subsidies rather than improving efficiency.
• Rent‑seeking behaviour – Companies may lobby for subsidies without delivering the intended social benefit.
• Targeting errors – Benefits may spill over to firms or consumers who are not the intended recipients (free‑rider problem).
• International trade issues – Export subsidies can provoke WTO disputes and lead to retaliatory tariffs.
• Inter‑generational equity – Large, long‑term subsidies can crowd‑out spending on future public goods (e.g., infrastructure, education).

8. Effectiveness Checklist (Syllabus 8.1 – “Application and effectiveness of measures”)

A subsidy is likely to be effective only if it satisfies all of the following criteria.

9. Equity, Redistribution & Measurement (Syllabus 8.2)

• Direct consumption subsidies – e.g., free school meals, subsidised public‑transport passes.
• Targeted production subsidies – e.g., grants to small‑scale farmers in deprived rural areas.
• Means‑tested vouchers – e.g., energy vouchers for households below a certain income threshold.

Impact can be evaluated using the Gini coefficient. A successful redistribution policy should lower the Gini, indicating a more equal income distribution.

10. Macro‑economic Link & Trade‑offs (Syllabus 10.3)

Subsidies interact with the four macro‑objectives, but they also create trade‑offs.

11. International Issues (Syllabus 11.1‑11.5)

• Balance of payments – Export subsidies can create a temporary surplus in the current account but may lead to capital‑account outflows if trading partners impose retaliatory measures.
• Exchange rates – Large fiscal outlays financed by borrowing can increase demand for foreign currency, putting downward pressure on the domestic currency.
• World Trade Organization (WTO) rules – Most export subsidies are prohibited under the Agreement on Subsidies and Countervailing Measures; violations can result in disputes and sanctions.
• Competitiveness – Domestic firms receiving subsidies may gain an unfair advantage over foreign rivals, potentially distorting global competition.
• Policy coordination – In a globalised economy, unilateral subsidies can lead to “subsidy races” that erode the net welfare gain for all parties.

12. Key Points to Remember (AO2 & AO3)

• Subsidies aim to move the market outcome toward the socially optimal level when positive externalities exist.
• The incidence of a subsidy depends on the relative elasticities of demand and supply; both consumers and producers share the benefit.
• Effectiveness hinges on correct identification of the market failure, optimal sizing, precise targeting, administrative efficiency and ongoing evaluation.
• Government failure – political bias, information gaps, rent‑seeking, fiscal unsustainability and inter‑generational equity concerns – can turn a well‑intentioned subsidy into an inefficiency.
• Subsidies can improve equity and support macro‑objectives, but they must be weighed against fiscal cost, possible inflationary pressure and international trade repercussions.