Subsidies defined as a form of support given to producers of a product that help reduce the cost of production, which results in an increase in production and consumption of that product. Goods that governments want to increase the consumption of are subsidized; such as education or healthcare. Government subsidies are usually given in the form of grants or loans.
The World Trade Organization has dedicated an entire chapter to the definition of subsidy which you can read here.
Example of a Subsidy
Subsidies can also be given to producers to protect their products from foreign competitors. For example, farmers in Europe receive a generous subsidy from the European Union. They’ve even gone and negotiated on the farmers’ behalf with supermarket chains such as Carrefour.
Types of Subsidies
A. Production subsidy
A production subsidy encourages suppliers to increase the production of a particular product by offsetting part of the production costs or losses. Production subsidies aim to expand production of a particular product so that the market would promote it without raising the final price to consumers.
Example of a Production Subsidy
The United States Federal Government heavily subsidizes corn. In 2010, U.S. farmers produced 32 percent of the world’s corn supply on 84 million acres of farmland, generating $63.9 billion in revenue.
Production subsidies can cause many problems including the additional cost of storing the over-produced products, depressing world market prices, and incentivizing producers to over-produce.
B. Consumption subsidy
A consumption subsidy helps to encourage specific consumer behavior. Usually, governments will subsidize such things as food, water, healthcare, and education.
C. Export subsidy
An export subsidy is a form of support from the government for products that are exported, as a means of assisting the country’s balance of payments. However, exporters can abuse this system.
Example of an Export Subsidy
Some exporters substantially over declare the value of their goods to benefit more from the export subsidy.
Another method is to export a batch of goods to a foreign country, but the same products will be re-imported by the same trader via a circuitous route and changing the product description to obscure their origin. Thus the trader benefits from the export subsidy without creating real trade value to the country’s economy.
D. Employment subsidy
An employment subsidy serves as an incentive for businesses to provide more job opportunities to reduce the level of unemployment in the country or to encourage research and development.
Example of an Employment Subsidy
Social security benefits are an example of employment subsidies.
Effect of a Subsidy Diagram
Economic Effects of Subsidies
- There is an increase in supply, i.e. the supply curve shifts to the right
- The Quantity consumed and produced increases from Q to Q*
- The Price decreases from P to P*
- The blue box is the amount of money the government spends on the subsidy
- Producers now earn P1BQ*0
- Consumers now consume Q* at P*