Question

There is no externality in the button market (true costs equal private costs and true benefits equal private benefits). However, to encourage button production the government places a subsidy of 2 cents on each button produced. On a supply and demand graph clearly identify:

(i) price and quantity produced without the subsidy,

(ii) price and quantity produced with the subsidy,

(iii) the price paid by buyers and received by sellers, and

(iv) any deadweight loss that might result from the subsidy.

Answer 1

In following graph, D0 and S0 are initial (pre-subsidy) demand and supply curves, intersecting at point A with initial price P0 and initial quantity Q0. The subsidy per unit will effectively lower production cost, increasing market supply, so supply curve will shift rightward to S2, intersecting D0 at point B with higher quantity Q1. Price paid by buyers is P1 and price received by sellers is P2, and unit subsidy equals (P2 - P1 = $2). Deadweight loss equals area of triangle ABC.