Unit 1 Micro: Revision on Producer Subsidies

Here is a planned answer to an exam question on producer subsidies

“Discuss the likely effects of a EU beef subsidy on the market for beef production in Wales”

The question does require some evaluation together with an analysis of the effect of a producer subsidy.

Focus on clear chains of reasoning, accurate diagrams and some evaluative comments at the end

A subsidy is a payment by a government to suppliers that effectively lowers their costs of production. Ceteris paribus, the effect of a subsidy is to increase supply and therefore reduce the market equilibrium price. This is shown in the diagram below. If Welsh beef farmers are offered a production subsidy, lower costs cause supply to shift vertically downwards by the value of the unit subsidy. Market price falls and the equilibrium output rises.

The financial cost to the European Union of providing a subsidy = new equilibrium output level x unit subsidy. This is shown in the diagram below

Evaluation

1/ The effect on equilibrium quantity in the market depends on the price elasticity of demand for beef i.e. if demand is inelastic, then lower prices for beef are unlikely to cause much of an expansion in market demand, the output effect of the subsidy will be limited. If demand is elastic, a gievn unit subsidy is likely to bring about a greater increase in quantity bought and this will increase the total spending on the beef farmer subsidy

2/ The subsidy provides a financial incentive for beef farmers to increase their output in the expectation of higher profits. But there will be time lags between the subsidy being offered and the likely expansion of market production.

3/ Other factors affecting the conditions of market supply in the beef industry might not be constant and could offset some of the effects of a subsidy - for example a rise price and cost of animal feed or energy and transport costs.

Background on subsidies

Different Types of Producer Subsidy

(1) A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price offered to farmers such as under the old Common Agricultural Policy (CAP).

(2) An input subsidy which subsidises the cost of inputs used in production – e.g. an employment subsidy for taking on more workers.

(3) Government grants to cover losses made by a business – e.g. a grant given to cover losses in the railway industry or a loss-making airline.

(4) Bail-outs e.g. for financial organisations in the wake of the credit crunch

(5) Financial assistance (loans and grants) for businesses setting up in areas of high unemployment – e.g. as part of a regional policy designed to boost employment