Microeconomics → Government Intervention → Subsidies | Part 6 of 7
Part 6 of our seven-part subsidy learning pathway. Compare production, consumer and investment subsidies, and discover why different types of subsidy affect economic decisions in different ways.
In our first five articles, we followed Luke, a dairy farmer who receives a government subsidy of 5p for every litre of milk he sells. We explored why this might encourage farmers to produce more, how the benefits could spread beyond farmers, and why the government must consider the cost.
But Luke's subsidy is just one example of government intervention — when the government takes action to influence how markets operate.
Governments provide subsidies for many reasons, including encouraging production, making goods more affordable, protecting employment and addressing market failure. Although the underlying economic principles are often similar, different subsidies can work in quite different ways.
Let's see how what we've learned from Luke applies to other industries.
1. Production subsidies: Luke and his dairy farm
Luke receives 5p for every litre of milk he sells. This is a per-unit production subsidy. The more eligible milk he sells, the more subsidy he receives, making additional production more financially attractive.
As we discovered, the subsidy encourages an increase in supply. In our simplified competitive-market model, the price paid by milk processors falls from 40p to 38p per litre, while farmers receive 43p per litre including the subsidy. The quantity traded increases.
But the benefits might spread further. Processors could pass some of their savings to supermarkets through lower wholesale prices. Supermarkets might retain some of those savings as higher profits or pass them on to shoppers through lower retail prices.
Farmers, processors, retailers and consumers could therefore all benefit, although how much each gains depends on competition, bargaining power and how prices are determined at each stage. Our original subsidy diagram shows only the market between farmers and processors; it cannot tell us exactly how the benefits are distributed throughout the wider supply chain.
Why subsidise dairy farmers in the first place?
Perhaps ministers want to support farmers' incomes. Or perhaps they believe dairy farming helps preserve attractive countryside that benefits people beyond those buying milk. These objectives aren't necessarily the same.
If the government wants to increase milk production, paying farmers for each litre sold provides a direct incentive. But if it wants to preserve attractive landscapes, producing more milk might achieve very little. Paying farmers specifically to maintain hedgerows or grassland could be more effective.
There's also a question about why dairy farmers receive support in the first place. Perhaps ministers believe there are sound economic reasons for helping them. But perhaps the farming industry is particularly effective at lobbying government. Why should Luke receive financial support while a café owner, furniture manufacturer or drone operator receives nothing?
We cannot establish the government's actual motives simply by examining its stated objectives. We'd need evidence about how the decision was made, which alternatives were considered and who influenced it.
This introduces the possibility of government failure. Government intervention can itself produce inefficient outcomes, perhaps because decisions are influenced by lobbying, political incentives or inadequate information.
Who enjoys the benefits — and who pays?
Suppose the subsidy really does help preserve attractive countryside. People living nearby, landowners and families able to visit regularly may enjoy those landscapes. But an inner-city family without a car or much leisure time might benefit considerably less.
Yet public money finances the subsidy. That family may contribute through taxation or lose out because resources are unavailable for other public services.
Meanwhile, Luke might be struggling financially. Equally, he might own valuable land and run a profitable farm shop and visitor attraction alongside his dairy business.
None of these possibilities automatically tells us whether the subsidy is justified, but they introduce two important economic considerations.
Efficiency concerns whether the intervention generates benefits that justify its costs. Equity concerns how fairly those benefits and costs are distributed.
A subsidy might achieve its stated objective without necessarily distributing the benefits fairly. Equally, a government might consider an intervention worthwhile partly because it helps people who would otherwise be disadvantaged.
2. Consumer subsidies: helping people buy electric cars
Suppose the government wants to encourage people to buy electric cars, perhaps because it hopes to reduce harmful emissions. Instead of paying manufacturers for every vehicle produced, it offers eligible buyers £2,000 towards purchasing an electric car.
This is a consumer subsidy. It makes the purchase more affordable for eligible buyers, encouraging more people to consider an electric car. In a standard supply-and-demand model, this can be represented as an increase in demand at each price received by sellers.
But does the buyer necessarily keep the whole £2,000 benefit? Not necessarily. If demand increases, manufacturers and dealers may be able to charge higher prices, allowing them to capture some of the subsidy.
We encountered a similar issue with Luke. Although the subsidy was paid to farmers, processors received part of the benefit through lower prices for raw milk. The recipient of government support isn't necessarily the only person who benefits.
The outcome also depends on how supply and demand respond. If manufacturers can easily increase production, the subsidy might lead to a substantial rise in sales. If production is constrained, more of its effect may be reflected in higher prices.
Of course, increasing electric-car sales isn't necessarily the government's ultimate objective. If the aim is to reduce pollution, we also need to consider whether the environmental benefits justify the public spending, and whether another policy might achieve the same objective more effectively.
3. Investment subsidies: helping Anna buy a machine
Now meet Anna, who runs a small furniture manufacturing business. Suppose the government offers her £20,000 towards purchasing a new machine.
Unlike Luke, Anna isn't being paid for every table she produces. She receives financial assistance towards an investment, perhaps because the government wants businesses to become more productive or increase their capacity.
Suppose Anna's new machine allows her to make tables using fewer labour hours per table. Her production costs may fall, making it more profitable to produce additional tables. In that case, her firm's supply could increase.
But several things could affect the outcome. Anna might not receive enough orders to use the machine fully, or the equipment might prove unreliable. Perhaps most importantly, she might have bought it anyway, without government assistance.
In that last case, the grant would have made little difference to her investment decision, even though public money had still been spent.
This illustrates why we need to understand exactly what the government is paying for before reaching for a familiar economic diagram.
Luke's subsidy directly increases the payment received for every litre of milk sold. Anna's grant helps finance equipment and may reduce her future production costs. Both could increase supply, but they work through different mechanisms.
4. Are there other forms of government support?
Yes. Governments can also use wage subsidies to reduce employers' costs of employing eligible workers, or provide grants for activities such as training and research.
They may offer subsidised loans, allowing businesses to borrow at favourable interest rates, or loan guarantees, which can make lenders more willing to provide finance.
There are also other forms of government intervention that don't work in the same way as subsidies.
For example, a guaranteed minimum price can support producers' incomes, but may create excess supply if the supported price is above the market equilibrium. A production quota restricts how much can be produced. Unlike a subsidy, a quota is a restriction rather than a payment.
We'll explore price controls, quotas and other forms of government intervention separately as we work through the A-level syllabus.
5. What do these examples have in common?
Although subsidies take different forms, we can investigate them using the same basic questions.
What is the government's objective? Is it trying to encourage production, make something more affordable, protect employment or address a market failure? And why was this particular industry chosen?
Who receives the support, and on what conditions? Does the government pay producers, consumers or particular businesses? Does the payment depend on output, purchases or investment?
How does the support change incentives? Does it make production more profitable, consumption more affordable or investment less expensive? How might people respond?
Who ultimately benefits — and who pays? The immediate recipient may not keep the full benefit. We also need to consider what happens elsewhere in the supply chain, how the policy is financed and whether the benefits are distributed fairly.
Finally, is the policy worthwhile? Does it achieve its objective? What evidence would help us judge? Could another intervention work better, or might the government make matters worse?
These aren't answers to memorise. They're questions that help us work through an unfamiliar economic problem.
What have we learned?
Luke's dairy subsidy, the electric-car grant and Anna's investment assistance are different forms of government support. All three attempt to change economic behaviour by altering incentives, but their effects depend on how the support is designed, how people respond and the conditions in the particular market.
We've also seen that understanding a subsidy involves more than drawing a supply-and-demand diagram. We need to ask why the government introduced it, whether it achieves its objective, who ultimately benefits, who pays and whether another policy might work better.
The lesson from Luke is therefore much bigger than milk production. We can apply the same economic reasoning in other industries, provided we recognise what's similar, what's different and which assumptions we're making.
In our final article, Subsidies in A-Level Economics Exams, we'll explore how to apply this understanding to unfamiliar questions, develop analysis and evaluation, and reach a reasoned judgement.
Continue the Subsidies Learning Pathway
← Part 5 — Do Subsidies Improve Economic Welfare?
Part 7 → Subsidies in A-Level Economics Exams: Analysis and Evaluation