Question

True / False / Explain: Government subsidies increase economic efficiency since producer surplus and consumer surplus increase.

Answer 1

False

A subsidy generally affects a market by reducing the price paid by buyers and increasing the quantity sold. Subsidies are usually pareto inefficient because they cost more than they deliver in benefits. Government subsidies create deadweight loss along with increase in consumer surplus and producer surplus.

The subsidy lowers the market price of good to consumers, and consumer surplus increases. The subsidy raises the revenues of producers , and causes their producer surplus to increase.

	free market	subsidy
consumer surplus	A+B	A+B+C+F+G
producer surplus	C+D	B+C+D+E
government revenue	0	-(B+C+E+F+G+H)
total surplus	A+B+C+D	A+B+C+D-H

since total surplus falls under subsidy than in a free market,we infer that subsidies create economic inefficiency.

Economic inefficiency is created by a subsidy because it costs a government more to enact a subsidy than the additional benefits to consumers and producers created by subsidies.

But in case of goods with positive externalities, subsidies increase the total surplus. Therefore,only in case of positive externalities subsidies increase economic efficiency