Question

The federal government gives subsidies to ethanol producers. Show graphically and explain how this affects the market for ethanol.

Answer 1

The initial market for ethanol and the effect of subsidy by government to ethanol producers is shown in the graph provided in the attached image file :

Subsidy means the discount given to producers of a chosen commodity by the government to lower the cost of production of that commodity.

As Government provides subsidy to ethanol producers, the total cost of production of ethanol went down. As a result, the producers can now sell and supply even more at the same given prices. This leads to an increase in production at same costs due to a decrease in cost of production. As a result of the increased production, the supply increases at all given prices. This means that the supply curve shifts to the right to accommodate increased quantities that are now supplied at all given prices. As supply shifts rightward, it cuts the demand curve at a new point E1, where a new equilibrium forms. At this equilibrium, we can see that the price has decreased but the total equilibrium quantity has increased. The demand curve stays the same because subsidy does not directly affect the decisions of consumers.

Hence, due to a subsidy by the government to ethanol producers, supply increases of ethanol which in turn lowers the equilibrium price from P0 to P1, and the equilibrium quantity increases from Q0 to Q1.