Question

Consider a small country that imports good Z. Some of the total quantity of Z domestically consumed is supplied by domestic producers and the rest of it is imported. Then suppose that the government pays a subsidy of S dollars on each unit of Z that is produced domestically, so that the quantity of Z imported is somewhat reduced (but not reduced to zero). Draw a demand and supply diagram that shows the effect of the subsidy. Compare this subsidy to a tariff. Explain why the subsidy is generally regarded as the more desirable policy instrument. (10 Marks, maximum word limit: 250 words)

Answer 1

a) The graph of subsidy:

  

b) When the government povides subsidy to domestic producers, taxpayers' money is used for subsidy. Before subsidy, Q3 was poduced by domestic producers, and (Q2 - Q3) was imported. After subsidy, Q4 is the domestic production; and imports reduce to (Q2 - Q4).

There is no loss of consumer surplus, as price paid by cosumers does not change. Whereas in the case of tariff, price increases and there is a loss of consumer surplus. Government spends subsidy amount which equals Q4 -times- subsidy amount (shaded rectangle). while in the case of a tariff, there is government revenue from tariff. Producers gain from both subsidy and tariff. There is deadweight loss in the case of subsidy, associated with supply curve. This is because the area marked 'X' is wasted. Although government spends that money as subsidy, it does not go to anybody. The rest of the subsidy amount goes to producers. However, deadweight loss is less in case of subsidy than in case of a tarriff. Deadweight loss associated with demand curve does not exist in case of subsidy as it does in case of a tariff. This is because consumerrs are not affected by subsidy as price they pay does not change. It is Pw before and after subsidy. Because of these reasons, subsidy is the desirable option.