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You are expected to evaluate/examine (AO3) subsidies and their effects on markets and stakeholders (SL+HL), draw (AO4) the effect of subsidies on price, production, consumption, and welfare (SL+HL), and calculate (AO4) the financial effect of subsidies (HL)
Subsidies (AO3, AO4)
Subsidies (AO3, AO4)
Subsidies are a form of financial assistance to producers by lowering their costs of production and encouraging higher output. There are 2 types of subsidies that can help protect trade:
Production subsidies: General subsidies meant to lower the cost of production of goods for domestic producers (reduces imports)
Export subsidies: Targeted subsidies meant to protect certain exporting domestic producers (increases exports).
This diagram explains how a normal subsidy (production subsidy) works:
Before subsidy:
Domestic producers produce at Q1, because price is at P1
Consumers consume at Q3, because price is at P1
Hence, the rest is imported (Q1 <-> Q3)
After subsidy:
Domestic producers get a subsidy of P1 <-> P2, so they produce as if the price is P2, so at Q2
Domestic consumers still get the price of P1, so they still consume at Q3
Hence, the new imported amount is Q2 <-> Q3
Effect of Subsidies on Markets and Stakeholders (AO3, AO4)
Effect of Subsidies on Markets and Stakeholders (AO3, AO4)
Effect on Consumers
There is no change for consumers, other than the fact that they now buy more domestic product
If domestically produced goods are of worse quality, then consumers will be worse off, but international trade diagrams assume homogeneous products
Effect on Producers
Since domestic producers get to produce at P2 and sell at P1 prices (and the government covers the rest with that subsidy), surplus increases
Foreign producers lose out as they now export less (Q2 <-> Q3, instead of Q1 <-> Q3)
Effect on the Market (Consumers+Producers)
Because the producer gain is larger than the consumer loss (because there is no consumer loss), the market experiences a positive surplus change
Effect on the Government
The government has to dish out a subsidy (shown as the blue rectangle on the first diagram on this page), which is taxpayer money it could have spent on other things (opportunity cost)
A welfare loss is still created, as some of the subsidy does not translate to surplus for producers (see the blue triangle). This is because due to the subsidy, producers are not as incentivized to produce as efficiently as before
Calculating the Effect of Subsidies (HL Only) (AO4)
Calculating the Effect of Subsidies (HL Only) (AO4)
This is very similar to calculating the changes in surplus and revenue for tariffs and quotas (just areas of triangles and rectangles)
Consumer Surplus and Expenditure (there is no change because consumers still pay the same price)
Domestic Producer Surplus and Revenue (use arrows to see changes)
Foreign Producer Revenue (use arrows to see changes)
Cost of Subsidy & Welfare Loss
This welfare loss comes from the fact that the government spends that rectangle, but only a portion of that goes to producer surplus. The rest is "lost" as producers lack the incentive to become more efficient, hence there is a welfare loss.
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