Microeconomics → Government Intervention → Subsidies | Part 1 of 7
Part 1 of our seven-part subsidy learning pathway. Start here, then follow the explanations, diagrams and exercises through to A-level exam application.
A subsidy is financial support from the government intended to encourage or support a particular economic activity. Governments might subsidise farming, public transport or renewable energy, for example.
But how does a subsidy actually work? Why might it encourage firms to produce more, and what happens to prices?
Let's use a fictional dairy farmer called Luke to find out.
Meet Luke
Luke runs a dairy farm. He sells his milk to a processor, which also buys milk from many other farms. The processor supplies milk and other dairy products to supermarkets, including major national chains.
We're looking at the market for raw milk sold by farmers to processors, not the price of milk on supermarket shelves.
At the moment, the processor pays Luke 40p per litre.
For simplicity, imagine there are lots of farmers and processors, none large enough to control the market price. Things are running fairly smoothly. Farmers are selling their milk, processors are buying what they need, and supermarkets are receiving the dairy products they want to stock.
At 40p per litre, the amount of milk farmers want to sell matches the amount processors want to buy. There is no persistent shortage or surplus of milk. Economists call this market equilibrium. It doesn't mean that everything stays exactly the same from day to day, but that there is no general pressure for the price to rise or fall.
Now imagine the government is worried about the future of dairy farming. Some farms are struggling financially, and ministers want to support farmers' incomes and encourage domestic milk production.
But why help dairy farmers rather than pubs, coffee shops or other businesses? And why choose a subsidy rather than another form of support?
Those are important economic questions, which we'll return to later in the series.
For now, suppose the government decides to pay farmers a subsidy of 5p for every litre of milk they sell. What happens next?
The government isn't making the milk itself. It is using public money to encourage farmers to produce and sell it. That money ultimately has to be financed through taxation or borrowing.
In other words, the government is directing resources towards an activity it wants to support. Whether this is a good use of public money is another question.
1. Why might Luke produce more milk?
Before the subsidy, Luke receives 40p for every litre he sells. With the subsidy, assuming the processor initially continues paying 40p, he receives 45p: 40p from the processor and 5p from the government.
At least, that's what Luke expects initially. He's assuming that the price processors pay will remain at 40p. But what happens when other farmers respond to the subsidy too?
His production costs haven't changed, but he now receives more money for every litre. That could make it worthwhile to produce more milk.
How could Luke do that? He could buy more cows, improve their feed so that each cow produces more milk, or invest in equipment that allows him to manage a larger herd.
Whether Luke increases production depends on his circumstances. Perhaps he has an unused field and plenty of room in his barn, in which case expanding production might be relatively straightforward. But if his barn is already full and he has no spare land, it could be much more expensive.
Luke therefore has to weigh up the additional revenue he could earn against the additional costs.
Suppose producing another litre of milk would cost him 43p. Before the subsidy, it wouldn't have been worthwhile because he would receive only 40p. But with the subsidy, he initially receives 45p, making that extra litre profitable.
Notice that the subsidy hasn't made his feed, labour or equipment cheaper. It has changed what he receives for his milk, making some increases in production more worthwhile than before.
2. What happens when every farmer receives the subsidy?
Luke isn't the only farmer receiving the extra 5p. Every eligible farmer receives it for every litre sold.
Some farmers might have spare capacity and find it relatively easy to increase production. Others might face much higher costs. Not every farmer will respond in the same way, or at the same speed, but overall the subsidy gives farmers an incentive to supply more milk.
At any given price paid by processors, farmers are now willing to supply more than before, provided they can increase production. Economists describe this as an increase in supply.
On a supply and demand diagram, it is shown by a shift of the supply curve to the right. We can also show this as a downward shift of the supply curve by the amount of the subsidy. Both describe the same change.
We'll build that diagram in the next article, but for now let's follow what happens in the market.
3. Why might the price of milk fall?
Remember that before the subsidy, the market was in equilibrium at 40p per litre. Now farmers are willing to supply more milk at that price. But are processors willing to buy all this additional milk at 40p?
Not necessarily. If farmers offer more milk than processors want to buy, there is a surplus at the original price. Farmers who want to sell their additional milk may be willing to accept a lower price from processors, putting downward pressure on the market price.
As milk becomes cheaper, processors may also want to buy more of it, provided they can profitably sell the additional dairy products. So the price paid by processors falls, while the quantity of milk bought and sold increases.
Eventually, the market may settle at a new equilibrium, where the amount farmers want to sell once again matches the amount processors want to buy.
4. Does Luke keep the whole 5p?
Not necessarily. Suppose the new market price paid by processors settles at 38p per litre. Luke now receives:
From the milk processor: 38p per litre
From the government: 5p per litre
Total received by Luke: 43p per litre
Before the subsidy, Luke received 40p. Now he receives 43p, so he is 3p better off per litre, while the processor pays 2p less. The government still pays the full 5p.
Remember the extra litre that cost Luke 43p to produce? Initially, when he expected to receive 45p, producing it looked profitable. But once the processor's price falls to 38p, Luke receives only 43p altogether. That extra litre now just covers its cost.
This illustrates why we need to distinguish between the immediate incentive created by the subsidy and the eventual market outcome.
We've chosen 38p simply to illustrate how the subsidy might be shared. We haven't calculated it from real-world data.
To predict the actual outcome, economists would need evidence about how strongly farmers and processors respond to changes in prices. We know the subsidy gives farmers an incentive to increase supply, but we cannot know precisely how the benefit will be shared just from the size of the subsidy.
Economists call the division of the subsidy benefit between buyers and sellers subsidy incidence. We'll examine that more closely in Article 3.
5. Does every subsidy have the same effect?
No. Think again about Luke and the other farmers. If many have spare land, buildings and equipment, they may be able to increase production relatively easily. The subsidy could lead to a substantial increase in milk supplied.
But if most farms are already operating close to capacity, increasing production may be difficult or expensive. The same subsidy might lead to a much smaller increase. It also matters how processors respond to lower prices, since they won't necessarily buy much more milk simply because it becomes cheaper.
And there is a cost to the government. If the subsidy is 5p per litre, the government pays 5p on every eligible litre sold, not just the additional milk produced because of the subsidy. A subsidy can therefore be expensive even when it produces only a modest increase in output.
Whether that is a worthwhile use of public money depends partly on what the government was trying to achieve in the first place.
What have we learned?
A subsidy changes the amount producers receive for what they sell. That can make additional production worthwhile, encouraging firms to supply more. But the response depends on their circumstances and costs.
If supply increases, the market price paid by buyers may fall. This means producers don't necessarily keep the full benefit of the subsidy, even though the government pays the full amount.
In the next article, The Subsidy Diagram Explained, we'll use Luke's example to build the supply and demand diagram step by step, so you can see how these changes fit together.
Continue the Subsidies Learning Pathway