Question

2- Consider a good in a perfectly competitive market. Suppose that a subsidy policy with a rate of
s (for example, 10%) is applied on the good. The buyers of the good will benefit from the subsidy.
Make a graphical analysis of this subsidy on market equilibrium.

Answer 1

In following graph, D0 and S0 are initial demand and supply curves, intersecting at point A with initial equilibrium price P0 and equilibrium quantity Q0.

The consumption subsidy increases demand, shifting D0 rightward to D1, which intersects S0 at point B with higher price (received by sellers) P1 and higher quantity Q1. Price paid by buyers is lower at P2.

Consumer surplus (CS) = Area between demand curve and price

CS before subsidy = Area EAP0

CS after subsidy = Area ECP2

Increase in CS after subsidy = Area P0ACP2, which is the gain to consumers.

Producer surplus (PS) = Area between supply curve and price

PS before subsidy = Area FAP0

PS after subsidy = Area FBP1

Increase in PS after subsidy = Area P0ABP1, which is the gain to producers.

Government cost of subsidy = Area P1BCP2

Deadweight loss = Area ABC