Subsidies and their incidence

The impact of a subsidy

A subsidy is a grant from the government to producers, usually per unit produced, to lower costs and encourage output.

Diagram in words: D and S1 cross at P1, Q1. A per-unit subsidy shifts supply vertically down by the subsidy to S2 (= S1 - subsidy). The new equilibrium where S2 crosses D gives a lower price for consumers, Pc, and a higher quantity, Q2. Producers receive Pc plus the subsidy, a higher price Pp, found by going up from the S2 point to S1 at Q2.

• Consumers: pay less and buy more; consumer surplus rises.
• Producers: receive more per unit and sell more; producer surplus rises.
• Government: pays subsidy per unit x Q2: the rectangle between Pp and Pc out to Q2. This has an opportunity cost: the money could fund other spending or lower taxes.

Incidence of a subsidy

• Consumer gain per unit = P1 - Pc: the part of the subsidy rectangle below the old price.
• Producer gain per unit = Pp - P1: the part above the old price.

The more inelastic demand is, the more of the subsidy goes to consumers as a lower price. If demand is elastic, producers keep more of the subsidy.

Evaluate: subsidies can make firms inefficient and dependent; they may be hard to remove; the government may not know the right size; and the benefit may go to producers rather than the consumers intended.

Worked example

Demand is Qd = 120 - 4P and supply Qs = -20 + 3P (equilibrium P = 20, Q = 40). A subsidy of $3.5 per unit is given. Find the consumer price, producer price, new quantity and the cost to the government.

1. New supply: Qs = -20 + 3(P + 3.5). Set equal to demand: Pc = 18.5, Q = 46.
2. Producers receive 18.5 + 3.5 = 22.
3. Consumer gain = 20 - 18.5 = $1.5 per unit; producer gain = 22 - 20 = $2 per unit.
4. Cost to government = 3.5 x 46 = $161.

Answer: Pc = $18.5, Pp = $22, Q = 46, cost $161.

Check yourself

1. Using the lesson's market, what is the total gain to consumers from the subsidy (consumer gain per unit x new quantity)?
   Show answer

   $69.00. 1.5 x 46 = 69.

2. A subsidy of $0.40 per unit is paid and 120,000 units are produced. Calculate the cost to the government.
   Show answer

   $48000. 0.40 x 120,000 = $48,000.

3. Before a $5 subsidy the price was $30. After it, consumers pay $27. What price do producers now receive?
   Show answer

   $32. Pp = Pc + subsidy = 27 + 5 = $32.

4. A per-unit subsidy to producers causes the supply curve to shift
   • downwards (to the right) by the amount of the subsidy
   • upwards (to the left) by the amount of the subsidy
   • so that it becomes vertical
   • to pivot around the price axis
   Show answer

   downwards (to the right) by the amount of the subsidy. Lower costs mean more is supplied at each price.

5. Consumers gain most of a subsidy when
   • demand is price elastic
   • demand is perfectly elastic
   • demand is price inelastic
   • supply is perfectly inelastic
   Show answer

   demand is price inelastic. Price falls by most of the subsidy when demand is inelastic.

6. Which is an opportunity cost of a government subsidy?
   • The money could have been spent on other public services
   • Consumers pay a lower price
   • Producers receive a higher price
   • Output of the good increases
   Show answer

   The money could have been spent on other public services. Government funds are scarce and have alternative uses.

7. Explain the impact of a subsidy on consumers.
   Show answer

   The subsidy shifts supply to the right (down by the subsidy), so the price consumers pay falls and the quantity they buy rises. Consumer surplus increases.. Shift, price, quantity, surplus.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.