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A subsidy is a grant given by government to encourage the production or consumption of a particular good or service.

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Introduction

TOPIC 2 A subsidy is a grant given by government to encourage the production or consumption of a particular good or service. (Anderton, 1999, P70) Subsidy, along with taxation, is known as an important form of government intervention in the market. Subsidies, for example, could be given on essential industries as housing and salt. Alternatively, they may be given to firms that employ disadvantage workers, such as people with disabilities. Governments may also subsidise firms to protect domestically produced goods in competition with imported goods. A subsidy will lead to a shift in the demand or supply curve, in turn this will affect the market equilibrium price level and equilibrium output of a good or service. The effect of a subsidy is depends on which side of the market, for example, buyers or sellers, is subsidised. The benefit generated from the subsidy will also be shared between consumers and producers according to the price elasticity of demand and supply. P S1 A1 S'1 B1 C1 D1 Q E1 F1 FIGURE 1 First, if the subsidy is paid to the producers, producers will have the incentive to supply more at any given price, because the subsidy indirectly reduced the cost of production. In this case, as shown in Figure 1, it will lead to a shift in the supply curve downward and to the right, therefore will affect the market equilibrium price. ...read more.

Middle

The reason for this is that the subsidy benefits most greatly to the side of the market that is less sensitive to price. In the market where supply is more elastic than demand, the increase percentage of supply will be larger than the increase percentage of the demand. Therefore the competition between producers will drive the price lower. An example could be the salt industry. Salt, as an essential good, actually has no close substitution. It causes the demand of the salt to be very inelastic. Therefore, if government subsidises the production of salt, most of the subsidy will be passed to consumers. By the same theory, if demand is more elastic than supply, there will be a stronger competition among consumers which will raise the price and leave a larger percentage of subsidy to the producers. S S' B (A) D FIGURE 4 C O In addition, if the government subsidise particular companies rather than the whole market, as in Figure 4, the part of benefit, AB, which used to belong to consumers will disappear. All the benefit of the subsidy will be received by the producers, because, in this case, the price elasticity of demand is perfect elastic, which means that there will be an unlimited quantity of demand at that price level. ...read more.

Conclusion

In this case, all the producer benefit, BC, will be transferred into consumer benefit. P A B (C) S FIGURE 8 D' D Q O E F To sum up, subsidy, as an important way of government intervention, affects the market by leading to a shift in the supply or demand curve, and therefore lead to a change of the market equilibrium price level and equilibrium output. However, the direction of change, in terms of equilibrium point will be different depends on which side of the market the subsidy is paid to. When the subsidy is paid to the producers, the supply curve will shift downwards and to the right, which will drive the equilibrium price to fall and drive the equilibrium output to increase. If consumer is the side that is subsidised, the demand curve will shift upwards and to the right, and both of the equilibrium price and equilibrium output will rise. The share of subsidy between producers and consumers, regardless of which side was subsidised, basically depends on the elasticity of the demand and supply curve. The side that responses slower to a change of price (less elastic to the price) will receive most of the benefit. Compared with the inelastic side, the elastic side has fewer alternative to switch to therefore has less market power and will have to give up most of the benefit of the subsidy. ...read more.

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