Subsidy Q&A

(this post refers to problem set 2)

Q:

Question 2 on the problem set mentions a subsidy. If you impose a subsidy on the producers, logically the supply curve must shift to the right, right?
I'm wondering this because we didn't really cover subsidies and in our work on taxes, only the quantity changed, not the S or D curves. Is this the same for subsidies? Also, wouldn't the government surplus be negative if it gave a subsidy to producers?

A:

In general, you are correct, but be careful with your terminology. With a tax (or a subsidy), the curves don't ACTUALLY shift. The drawing of the new curve that we did is called an "effective shift". This is because none of the determinants of demand or supply actually changed, but once we have a tax we have the supply curve in terms of the price that the producer keeps, and the demand curve in terms of the price that the consumer pays. When we draw the effective supply curve for example, this represents the production of the suppliers as a function of the price that the consumer pays, so that we can then compare apples to apples and get an equilibrium. With your subsidy question, your effective supply curve would be to the right of the actual supply curve.

If you recall our work on taxes, we talked about two methods of finding the new equilibrium once a tax is imposed. One was to draw the effective supply or demand curve and find the new equilibrium that way. The other was our wedge story, which is what I think you are referring to. In this analysis, the curves don't shift, but you look for the quantity where there is a vertical distance the size of the tax between the demand and supply curves (to the left of the old equilibrium). In this case, the price that the consumer pays (found on the demand curve) is greater than the price that the producer receives (on the supply curve) by the amount of the tax. For a subsidy, you would have to look to the right of the old equilibrium to find a similar wedge, since with a subsidy the price that the consumer pays is less than the price that the producer receives. (Basically, a subsidy is just a negative tax) Government surplus would indeed be negative, since they are paying out money and (in our model) not getting anything in return. This makes sense mathematically if you think about the equation I gave for government revenue and then consider that the subsidy is a negative tax, so T would be less than zero.