Producer Subsidies [ Biz/ed Virtual Developing Country ]

The Virtual Developing Country is a case study of Zambia. This trip is the Rural Life and Agriculture Tour and this page looks at the effect that giving a subsidy to a firm has on the market equilibrium.

Theories

Producer Subsidies

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The aim of a producer subsidy is to increase the domestic production of a good.

Producer subsidy - supply curve shifts

By governments giving a certain amount of money for each unit of good produced to the producers the domestic supply curve makes a shift to the right from S1 to S2. The vertical difference between the two supply curves represents the amount of the subsidy per unit.

The model predicts that the amount of the good offered for sale will increase from Q1 to Q2 and the price will fall from P1 to P2.

The concepts of consumer and producer surplus can be used to examine the impact of the producer subsidy on overall welfare. The fall in the price suggests that the consumers are going to benefit. Consumer surplus is a measure of welfare gained by consumers being able to purchase a good or service in the market place at a price lower that the maximum that they would be prepared to pay for it rather than going with out it. In the diagram below, it is shown by the triangle above the equilibrium price.

Consumer surplus

Inspection of the subsidy diagram above shows that the consumer surplus has increased as a result of the price falling following of the granting of the subsidy.

There will also be a benefit to producers from a lowering of their costs as a result of the subsidy. This results in an increase in producer surplus. The producer surplus is shown in the diagram below by the triangle below the equilibrium price. The producer surplus arises because the producer sells the good for more than they would be willing to. Once the subsidy has been given, this producer surplus increases.

Producer surplus

The overall welfare gain is shown by the sum of the consumer and producer surplus.

Next theory - The Coffee Market >>