Calculating the effects of subsidies

In this section we'll approach the effects of subsidies through linear equations as we did with indirect
taxes.
Again, this can be done using simultaneous linear equations for demand and supply, or using data
directly from a graph, after plotting the demand and supply curves before and after the subsidy.

Important
A subsidy also creates a wedge between the price consumers pay (Pc) and the price producers
receive (Pp). In this case, as producers receive the market price plus the subsidy, Pp = (Pc +
s) or (Pp - Pc) = s

Calculating the subsidy effects

using simultaneous linear equations
Based on the demand and supply linear equations, and the fact that producers receive the price paid
by consumers plus the subsidy per unit of output paid by the government, we have the following
three conditions:
Qd = a - bP
Qs = c + dP
Pp = Pc + s , where Pp is the price received by producers, Pc the price paid by consumers, and 's' the
subsidy per unit paid by the government.
or seen otherwise, consumers pay producer's price minus the amount of the subsidy per unit:
Pc = Pp - s
Replacing each price in the corresponding equation the supply curve becomes:
Qs = c + dP = c + d Pp = c + d (Pc + s)
And the demand curve is:

Qd = a - b Pc
Therefore we have the following two equations to solve the equilibrium price in the market, which is
the price paid by consumers, Pc :
Qs = c + d (Pc + s)
Qd = a - b Pc
Once we found Pc, we can find Pp and the equilibrium quantity, Qt.
Let's try an example. The procedure is similar to the one seen for indirect taxes previously.

Example 1
Solve the following questions assuming that a subsidy of 1.5 per unit is granted to milk cartons of
1/2 liters, whose original demand and supply curves are described by the equations:
Qd = 12 - 2P
Qs = 1 + 2P , where the price is in Euros and the quantity is in thousands of 1/2 litres per month.
1. Calculate the equilibrium price and quantity before the subsidy.
2. Calculate the price paid by consumers (new equilibrium price), the price received by
producers, and the new equilibrium quantity after the subsidy.
3. Calculate government's total cost because of the subsidy.
4. Calculate the change in producers' total revenue after the subsidy.
5. Calculate the change in consumers' total expenditure after the subsidy.
Guided Answers:
1. Calculate the equilibrium price and quantity before the subsidy.
This procedure we've learnt before. We'll skip to the answer.
P = 2.75
Q = 6,500

Answer: The equilibrium price is 2.75 and the equilibrium quantity is 6.5 thousand cartons of
milk per week before the subsidy.
2. Calculate the price paid by consumers (new equilibrium price), the price received by
producers, and the new quantity after the subsidy.
Step 1 - Rewrite the demand and supply curve replacing Pc in the demand curve and Pp instead of P,
where the price received by producers is equal to the price paid by consumers plus the subsidy.
S2 = Qs = 1 + 2Pp
D1 = Qd = 12 - 2Pc
Pp = Pc + s
Set supply equal to demand.
S2 = D1
1 + 2Pp = 12 - 2Pc
Replace Pp.
1 + 2(Pc + s) = 12 - 2Pc
To find the new equilibrium price, replace s = 1.5 (the subsidy per unit) and solve Pc.
2 (Pc + 1.5) = 11 - 2Pc
2Pc + 3 = 11 - 2Pc
4Pc = 8
Pc = 2
Step 2 - Now, determine the new equilibrium quantity by substituting the price into the demand
function.
D1 = Qd = 12 - 2Pc = 12 - 2 (2) = 12 - 4 = 8
S2 = Qs = 1 + 2Pp = 1 + 2 (Pc + s) = 1 + 2 (2 + 1.50) = 8

Qs = 8,000
Step 3 - Finally replace the price paid by consumers to find the price received by producers.
Pp = Pc + s = 2 + 1.50 = 3.50
Answer: The new equilibrium price is 2.00 (price paid by consumers), the price received by
producers is 3.50, and the equilibrium quantity is 8 thousand cartons of milk per week after the
subsidy.

Try for yourself!

3. Calculate the government's total cost because of the subsidy.
+ Show answer

4. Calculate the change in producers' total revenue after the tax.

Be Aware
Remember that now the total revenue for producers is the amount of units sold multiplied by the
price paid by consumers, plus the subsidy received from the government per unit sold.
Therefore, the change in total revenue is calculated by:
TR = TR2 - TR1
TR1 = Q P , where Q is the equilibrium quantity before the subsidy and P is the equilibrium price
before the subsidy.
TR2 = Qs Pp , where Qs is the new equilibrium quantity after the subsidy and Pp is the total price
received by producers after the subsidy.
TR2 can also be expressed as TR2 = (Qs Pc) + (Qs s)
All these values have been calculated in the previous questions.
TR1 = 6.5 2.75 = 17,875 (question 1)
TR2 = 8 3.50 = 28,000 (question 2)

Then,
TR = TR2 - TR1 = 28,000 - 17,875 = 10,125
Answer: The change in total revenue for producers is an increase of 10,125 per month.

Try for yourself!

5. Calculate the change in consumers total expenditure after the subsidy.
+ Show answer