Subsidy: an amount of money paid by the government to a firm per unit of output. This causes the supply curve to shift to the right by the amount of subsidy.
Aims of subsidies
To ensure consumers can afford necessary goods: the price of the product will be lowered so that more consumers are able to buy.
For instance in Malaysia millions is being spent in order to subsidise food and fuel to keep prices low. Like sugar which is an essential ingredient in Asian cooking. (July 2012).
Protectionism: subsidies are used to help domestic firms become more competitive in the international markets therefore increasing export revenue. This is in order to address a balance of payment deficit.
For example the USA subsidises their steel industry, in order to protect it against countries, such as Brazil, where steel can be produced more cheaply.
To ensure consumers buy merit goods: merit goods are goods or services which are provided for the benefit of society. They are usually under-consumed and under-supplied, this is a result of information failure about the private and external benefits the good can have. Therefore, the government subsidises them in order to make more consumers willing and able to consume.
Examples of merit goods are pensions, healthcare, insurance and education. In Columbia for instance health insurance is subsidised.
Guarantee the supply of products: the government may believe that some industries need to be supported by lowering their average costs of production. This may be in order to ensure them for future times such as war. Also this could be to provide employment.
For instance the power supply in India is most states is subsidised as the government believes it is necessary for the economy.
When subsidies are provided, the market will expand in size (increase in quantity), thus possibly raise the level of employment in the market, since firms might employ more people. (Curve shifts down because costs of production decrease).
Producer: revenue increases from P1Q1 to P3Q2.
Consumer: price per unit decreases from P1 to P2
Cost to government: P3P2Q2
The total cost of the subsidy exceeds the benefit of the consumers and producers so there is a loss of welfare, a deadweight loss
Subsidies may undermine foreign firms. For instance developed countries may have subsidised farming making their products cheaper than underdeveloped countries.
Firms may become inefficient as they are not competing against foreign firms.
There is an opportunity cost as the government spending on the subsidy could have been put to other projects