Calculating The Subsidy Effects After Plotting Them On A Graph

Calculating the subsidy effects after
plotting them on a graph

As we did for taxes, let's now try to plot the same example from the previous section on a graph, and
use the data from the graph to answer the questions.
First, plot both original demand and supply functions for milk on a graph, as shown in Figure 1.
Both equations are:
D1 = Qd = 12 - 2P , and
S1 = Qs = 1 + 2P , where the price is in Euros and the quantity is in thousands of 1/2 cartons per
month.
The market equilibrium can be found where S1 = D1 , at P = 2.75 and Q = 6,500.
Now assume that a subsidy of 1.5 per unit is granted to 1/2 litre cartons of milk as shown in Figure
2 below:
Figure 1.
Market equilibrium of milk before the subsidy.
Figur
e 2. Subsidy granted for milk.
When a subsidy is granted, we know that the supply curve shifts downwards by the amount of the
subsidy. Therefore, we can find any two points to draw it.
An easy point to find is always at the previous equilibrium quantity where Q = 6.5 in this
example. The new supply curve will pass through a price of 1.5 below the previous equilibrium point
of 2.75, at P = 1.25.
Find any other point with the same criteria and now we have the new supply curve S2 as shown
in Figure 2, from where we can deduce all the other effects of the subsidy. Table 1 summarises
these effects.
Table 1. Effects of a subsidy of 1.5 per carton of milk.
Variable
Before the subsidy
After the subsidy
Equilibrium
price
2.75
2.00
Equilibrium
quantity
6,500
8,000
Price paid by
consumers
2.75
2.00
Price received
by producers
2.75
3.50
12,000 = 1.5 8,000 (unitary subsidy times new quantity

consumed after the subsidy). Shown by the area 'b + c + d + e +
f + g + h' in Figure 2.
Total cost for

government
Consumer's
expenditure
17,875 = 2.75 6,500

(previous equilibrium price times
the equilibrium quantity before
16,000 = 2.00 8,000 (new price paid by consumers times

new quantity consumed after the subsidy). Shown by the area 'i
Variable
Producer's
revenue
Producer
surplus gain
Consumer
surplus gain
Welfare gain
for the milk
market
Before the subsidy
After the subsidy
the subsidy). Shown by the area

'e + f + i + j + l' in Figure 2.
+ j + k + l + m' in Figure 2.
17,875 = 2.75 6,500

(previous equilibrium price times
the equilibrium quantity before
the subsidy). Shown by the area
'e + f + i + j + l' in Figure 2.
28,000 = 3.50 8,000 (new final price received by producers

times new quantity sold after the subsidy). Shown by the area 'b
+ c+ d + e + f + g + h + i + j + k + l + m' in Figure 2.
Producer surplus now increases and is represented by the area

'b + c' in Figure 2 (area below the new producers' price and
above the original supply curve). In monetary terms this would
be 5,437.50 = 6,000 (area 'b + c + d') - 562.50 (area 'd').
Area 'd', which is a rectangle triangle, is calculated as half of the
area of a square at that point: (3.5 - 2.75) (8,000 - 6,500)
1/2.
Consumer surplus now increases because they pay a lower

price and consumes a greater amount of the good, this is
represented by the area 'e + f + g' in Figure 2. In monetary
terms this would be 5,437.50 = 4,875 (area 'e + f ') + 562.50
(area 'g'). Area 'g', which is a rectangle triangle, is calculated as
half of the area of a square at that point: (2.75 - 2) (8,000 6,500) 1/2.
10,874 = 5,437,50 + 5,437,50 (total gain of consumer

surplus plus producer surplus). Shown by the area 'b + c + e + f
+ g' in Figure 2.
Variable
Society's
welfare loss
Before the subsidy
After the subsidy
1,125 = 562.50 + 562.50 (the cost of the subsidy to the

government minus the welfare gain on consumers and
producers of milk). Shown by the area 'd + h' in Figure 2. Both
which are rectangle triangles, therefore, can be calculated as
half of the area of a square.
From Table 1 we can conclude that after granting a 1.5 per carton of milk:
The government has a cost of 9,750.
The price that consumers pay decreases with 27.27%.
The price that producers receive increases by 27.27%.
The quantity of milk consumed raises with 23.08%.
Consumer's expenditure decreased with 1,875 a month.
Producer's revenue increased by 10,125 a month.
Consumer's surplus increased by 5,437.50.
Producer's surplus increased by 5,437.50.
The society has a total welfare loss of 2,250.
Important
A subsidy produces a net welfare loss to society because the consumers and producers of the
subsidised good gain less welfare than what society loses by the cost of the subsidy.

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Calculating the subsidy effects after

plotting them on a graph

Table 1. Effects of a subsidy of 1.5 per carton of milk.

Before the subsidy

After the subsidy

12,000 = 1.5 8,000 (unitary subsidy times new quantity

Total cost for

17,875 = 2.75 6,500

16,000 = 2.00 8,000 (new price paid by consumers times

Table 1. Effects of a subsidy of 1.5 per carton of milk.

Before the subsidy

After the subsidy

the subsidy). Shown by the area

17,875 = 2.75 6,500

28,000 = 3.50 8,000 (new final price received by producers

Producer surplus now increases and is represented by the area

Consumer surplus now increases because they pay a lower

10,874 = 5,437,50 + 5,437,50 (total gain of consumer

Table 1. Effects of a subsidy of 1.5 per carton of milk.

Before the subsidy

After the subsidy

1,125 = 562.50 + 562.50 (the cost of the subsidy to the

The government has a cost of 9,750.

The price that consumers pay decreases with 27.27%.

The price that producers receive increases by 27.27%.

The quantity of milk consumed raises with 23.08%.

Consumer's expenditure decreased with 1,875 a month.

Producer's revenue increased by 10,125 a month.

Consumer's surplus increased by 5,437.50.

Producer's surplus increased by 5,437.50.

The society has a total welfare loss of 2,250.

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