How Does a Consumer Subsidy Impact Industry Equilibrium and Prices?

[Tre75v]

Hi all, hope this is in the right spot.I have just started undergrad studies and I have an essay question asking how an industry will react to a consumer subsidy.Our textbooks don't cover it, and the lecturer won't answer question, and google has failed me.
I am seeing the supply curve shifts to the right, I cannot work what to do about equilibrium price.
I have P2Q2 marking the new quantity demanded to show the subsidy amount.
I am in serious trouble here, can anyone point me in the right direction please.
View attachment Graph.doc

 

[Matterwave]

So, if you subsidize consumers, then in effect at every price P, they only "see" a price P-S where S is the subsidy (assuming a per-unit subsidy).

So, let's just say the price is $10 and the subsidy is $5. The consumer then only sees the price as $5 and will buy however many he demanded at $5. This is shown through a shifting out of the demand curve. This means, that, in general (if we assume downward sloping demand), the consumer demands more at a given price P. The seller can then maximize profits to reflect such an increased demand. The general rule is then higher sales and higher prices.

The supply curve shouldn't shift since the subsidy is applied to consumers.

So you have the same supply curve, and a shifted demand curve. The new intersection of which is the equilibrium.

 

[Tre75v]

I battled this one for 4 days, I was thrown off by youtube lectures talking about a subsidy to producers.
Correct me if I'm wrong, but demand curve shifts right and up by the amount of the subsidy.
The supply curve will remain where it is , but the cost of producing additional units will increase the price to a new equilibrium point at the intersection of Supply curve and New demand curve.
I appreciate your help heaps Matterwave.

 

[imiyakawa]

Matterwave basically answered your question. It is up to you to extrapolate consequences of what he said to industry.

but the cost of producing additional units will increase the price.

BUT, I think there might actually be a shift in the supply curve as well as the demand curve if you consider what you said: the law of diminishing returns. As the consumer subsidy increases, demand increases, and at some point the cost/unit of production increases (law of diminishing returns). THIS WOULD CAUSE A SHIFT IN THE SUPPLY CURVE, as producers are less inclined to supply. So there would be two competing elements. Of course, consumer demand (shift in D-curve) would outweight increased costs per unit (shift in S-curve) by a huge margin, but the process is there.

----------------------------------------------

ALSO, the question asked the consequences of this subsidy to industry. You should talk about how perhaps, if it was an oligopolistic industry, new players would flood into the industry resulting from increased demand and the market may actually become monopolistic or perfect-competition in its tendencies.

You could then talk about future potential consequences of this if the subsidy was removed, and how the industry would be forced back to equilibrium; i.e. all excess firms will die out.

You could then talk about how, post-subsidy, the amount of firms left over actually EXCEEDS the amount of firms in the initial market, EVEN IF THE POST-SUBSIDY DEMAND IS THE SAME SIZE AS THE PRE-SUBSIDY DEMAND. This is because these extra firms have overcome all natural barries to entry that was stopping perfect competition in the original market!

 

[Tre75v]

Once again, I can't thank you people enough.
I very much agree with the effects on the industry, it's only week 3 though and they know we should not have touched on those topics yet,i.e. Monopoly/Oligopily etc.
The only situation I have seen the supply curve shift has been in a producer subsidy.I may not have been totally clear in that this is a consumer subsidy, in fact a rebate. I was thinking it would shift also, but it seems to be a simple income increase.I was thinking of it as a price reduction which is wrong.What I have seen is that the quantity supplied will move up a little to intersect with the new demand line as cost of producing additional units increases and if you graph it with hypothetical figures(not the graph I tried to attach yeasterday) shifting the demand curve one unit right effects a rise in the supply curve of half a unit.So the consumer gets half the subsidy, the supplier/producer gets the other half to cover costs for increasing short run production.
A shift in the supply as well curve shows an increase of total unit production at the same price, but the producer is supplying as much as he is willing to at that price, he must take up some of the subsidy and in turn calm the demand.

 

[imiyakawa]

Yes, the consumer subsidy, in theory, should only cause a shift in the demand curve.

BUT, what I was saying is that there will actually be a slight shift in the supply curve ASWELL, as the increase in demand --> increased units needed to be produced by suppliers --> increase cost per unit (law of diminishing returns) --> shift in the supply curve to the left (a very very small shift).
- Say that this model requires the following assumption before it represents reality: The law of diminishing returns schedule's peak is surpassed by the increase in demand.
- Say that this wouldn't happen often in reality.

It matters not that you haven't covered monopoly/oligopoly market structures yet, all you have to do is give 1/2 sentences, something like: the increase in demand will not only cause current producers to increase their supply, but will endear new firms into the market which could, in potentia, transform the market structure towards either a perfectly competitive or monopolistic market.

"This consumer subsidy may actually be used to overcome market failure in the provision of specific goods whose monetary loss outweighs that of expected monetary gain (for entering the market), even if demand for such a good exists. In this instance, the consumer subsidy is acting as a surrogate for direct government intervention in the provision of the good, thus satisfying the neoclassicalist goal of privatisation. Consequently, if used for this purpose, this subsidy could actually be thought of as a Bayesian Efficiency Incentive, in that the market player (a firm) requires an incentive, direct to them or otherwise, in order to behave Pareto Optimally. However, according to contemporary economic theory, if a market failure exists it is Pareto Suboptimal. Although, if one was to consult Keyensian economics in this instance, one would be encouraged to believe that the inefficiency resulting from market failure can be reduced by intervention."
- AN ENTIRE PARAGRAPH IN YOUR ESSAY, FULLY EDITED.

Make sure you also discuss the point I made in the last paragraph of my last post.

Happy to answer ANY questions.

Of course, this is beyond what you're currently expected to know, but there's nothing wrong with getting good marks.

 

[Tre75v]

Thank you so much, I can't believe that I started only 19 days ago and I not only understand what you wrote, but can formulate an opinion.I am loveing Microeconomics, but it's my first unit of a Business Degree.Are you guys doing Economics, or is this just part of your core units? I am just really loving it, but the only other unit I have to compare with is an intro to Uni one, and it is touchy feely crap, so you can't really fail.lol

 

[imiyakawa]

I'm also doing a business degree, with a major in Economics (2nd year of uni atm). I did ECON because it's by far, in my opinion, the most enjoyable subject in a business degree: everything else seems dry and wrote-learnt in comparison, in that there is ZERO reasoning encouraged, just application of set ways of thinking/formula. Sure, this may contribute to the productive process in a similar way an economics graduate might, but god is it boring.
What country are you doing your degree in? Australia? (you use the word "heaps" and you call uni uni). I go to UTS.

 

[CRGreathouse]

BUT, what I was saying is that there will actually be a slight shift in the supply curve ASWELL, as the increase in demand --> increased units needed to be produced by suppliers --> increase cost per unit (law of diminishing returns) --> shift in the supply curve to the left (a very very small shift).

No, actually. The production cost per unit will rise by the law of diminishing returns, but this is a movement along the supply curve, not a shift in the supply curve.

 

[imiyakawa]

No, actually. The production cost per unit will rise by the law of diminishing returns, but this is a movement along the supply curve, not a shift in the supply curve.

Only an increase in price can cause a movement along the supply curve. Any increase in the cost of production causes the supply curve to shift.

Wikipedia:
'When the suppliers' costs change for a given output, the supply curve shifts in the same direction.'

bized.co.uk:
'Therefore, an increase in the costs of production will cause a leftward shift in the supply curve.'

 

[Tre75v]

costs change for a given output,

I was thinking the supply curve would shift too, I think when they say cost change of given output they mean that the cost of producing at current levels increases.and if the demand had not increased nothing would have changed production cost of the given output. so the extra demand at say $500(what my essay discusses) will not be fully met as suppliers don't want to produce that quantity at that price..the rationing function of prices says that the extra demand at $500 more income will cause under supply, so customers will bid prices up due to limited stock, as well as the extra cost or producing additional units for the producer.They naturally will meet in the middle, half saved by the consumer, half to the producer to make it worth their while, and government has invested in long term solutions and saved on dams and desalinisation plants.Win,win,win.
Oh, it's about the water tank subsidy by the way

 

[Tre75v]

I'm doing online study through Open Universities, I just didn't want to drive into the city every day and hang out with people half my age, feel like a pervert.lol, and I can study through different Universities.The only problem is you become your own lecturer, and youtube has been my best friend.lol. I'm base in Brisbane, and I am in my first study period of my first year, bit scary, we have 2 units per study period, 4 SP's per year.I think it may be different on campus? I have started on Bachelor of Business Studies, but like you, I am leaning towards Bachelor of Business, with economics major.Might see how this unit goes before I decide.

 

[imiyakawa]

costs change for a given output,

I was thinking the supply curve would shift too, I think when they say cost change of given output they mean that the cost of producing at current levels increases.

Ah yes, the following confusing sources don't help:

• 'A shift in the supply curve is caused by a change in any non-price determinant of supply.'
• 'an increase in the costs of production will cause a leftward shift in the supply curve.'

Of course,
(A) it'll cause a movement along the supply curve
(B) the supply curve will be curved as an arc with a trough.

-----

At UTS we can either do 4 subjects a semester or 2, depending on your preference. Truthfully I would've liked to do my degree on-line, I'm always skipping my lectures because it's such a hassle to go when I can read the slides/do the textbook stuff and get away with that way.

 

[imiyakawa]

Other stuff on the consumer subsidy
http://www.stanford.edu/group/FRI/indonesia/courses/manuals/multimarket/Output/chapt1.html
To get to the correct point, go to that URL and press CTRL+F and type "consumer subsidy" without quotes and read the few paragraphs under that.
Also consider reading the last few points of my last post in the other thread dealing with the consumer subsidy.

 

[Tre75v]

Figure 1.9 illustrates the effect of a consumer subsidy on rice from the perspective of the government. In the example, the government is setting the domestic price of rice to both producers and consumers below the border price, causing domestic rice consumption to increase, and domestic production to decline. The deficit (Q3 - Q2) must be purchased by the government at world prices and then resold to consumers at the lower domestic price. In order to do so, it incurs a budgetary cost shown by the shaded area in the diagram. The area is equal to the subsidy on each unit (Pw - Pd) times the number of units imported

That's a price ceiling (price ceiling)"...is the maximum legal price a seller may charge for a product or service." in this case to clear a surplus, and it seems the government is subsidising the producer to pay international prices. My example is a subsidy in the form of a rebate to the consumer, thus increasing income and demand.
no wonder this is a theoretical science if you sounded convincing enough nobody could dispute what you say.lol

 

[Tre75v]

On another note, I have a question about price elasticity of demand on the rainwater tanks.
Determinants are Substitutability,proportion of income, Luxuries v Necessities and time.
I have down it is a substitute for tap water, and the subsidy makes it more affordable tahn before, plus increases in water bills mean that the one off expense works out less costly, also the $500, even though it ends up as $250 real, as a reasonably high portion of income, I think it is a luxury as we have domestic water, but water restrictions mean we can't wash cars and water gardens, time frame is 6 years, so consumer tastes will swing as habits are broken.Any thoughs before I hand this in.I hate looking like a fool, so I am second guessing myself

 

[Tre75v]

BTW, thanks heaps for that link, a bit advanced for me, but that's the best way to learn.

 

[mel*k]

Hi Tre75v,
Just wanted to thankyou for your post I am trying to work out the same question as you are. I am finding it quite hard to get my head around economic models and subsidies, are you moving the demand curve to the right as there will be an increase in demand and leaving the supply curve as is? or will the supply curve shift too?

Thankyou in advance

 

[imiyakawa]

Read the thread

 

[Tre75v]

I got the demand curve moving one unit, and as it is sloping, the actual rightward movement is only half the subsidy, the rest it taken by the producer with supply moving up the supply line.This is because the increase in demand is above the equilibrium level, therefore the supplier does not wish to produce more, so production prices rise and consumer saves half from original equilibrium price.It is all in the thread, go back to page 1.Are you studying on campus or OUA like me?
Remember, this is a subsidy to the consumer.PAJ Holden and others talk about Subsidy to the producer on youtube.This is different.it is an increase in money income only.Does not do anything for the producer except increase demand.Correct me if I'm wrong.My assignment goes in tomorrow.The elasticity thing has me worried if anyone has thoughts?

 

[mel*k]

Thankyou, i was finding it really hard to find anything on the net about consumer subsidary.
I am studying through OUA too, i am finding it really interesting but finding it hard to apply the concept. Good Luck with it (:

 

[Tre75v]

we have a study group on facebook for OUA people.mostly full of useless leaches, but at least 4 people are helpful.here's the link if you are keen Mel.and
also.I have submitted my assignment.matterwave imiyakawa and crgreathouse, if I do well I owe it all to you guys.if I fail, I blame you guys.lol.seriously, thank you very much.http://www.facebook.com/?sk=messages#!/group.php?gid=381995301000

 

[brainstorm]

I think the way to approach a consumer subsidy is to consider the overall relationship created between production and consumption by such a subsidy.

To make it simple, let's imagine that the level of the consumption subsidy would be set such that consumers would be able to attain a minimum standard of living with just the subsidy and no further income.

To further simplify, let's assume that all consumers reduce their consumption to the minimum standard of living in order to avoid participation in the labor market.

At that point, consumption would cease to function as a motive for production and, accordingly, production would either cease or would have to become mandated by some other means than costs/debt.

Theoretically, prices are supposed to be set as a result of production costs and relative scarcity. If consumption remains below production levels, a surplus ensues and if supply is sufficiently competitive, prices will fall until production drops to a level that brings the quantity produced in line with the quantity consumed.

Once production drops to match consumption levels, however, any increase in demand will result in scarcity, which will drive the price up and motivate producers to increase production to profit from the increasing prices.

I don't think that a consumer subsidy actually necessarily affects prices or demand one way or the other. It is quantity consumed verses quantity produced that generates relative abundance or scarcity, and price changes as a result of that.

A subsidy, on the other hand, has to come from somewhere - so assuming that the subsidy has to be paid for by taxes, the need to pay taxes becomes the motive for production revenues. This is still assuming that there is no consumer desire to spend beyond the subsidy allowance.

Thus, regulation of production and labor would shift from supply-side competition to the distribution of the tax-burden at determined by government. Presumably, the government would have to tax the recipients of subsidized spending in order to recover the money in order to continue redistributing it to consumers.

The question is why anyone would want to take a position in production or labor if they would receive the same consumption subsidy as anyone else. Presumably, those who take more responsibility and do more would want privileges beyond minimum consumption. For that to be possible, though, goods and services would have to be produced beyond that attainable through the subsidy amount alone.

This would result in class-differentiation, presumably, where producers/workers attained higher status and more material amenities and services than those who relied on subsidized consumption alone.

If the producers/workers would become dissatisfied with their level of privilege, seeing for example that those who lived with less were actually happier, they could become disenchanted and demand more labor from those receiving subsidies. This is basically what has happened in the past as a result of subsidies and uneven distribution of production and labor activities.

It would be more effective, imo, to improve the distribution of labor than to subsidize consumption. Provided that everyone would take a share of responsibility for production, no subsidy would be needed for consumption, that is unless wages were insufficient for people to consume the fruits of their labor.

 

[EnumaElish]

BUT, I think there might actually be a shift in the supply curve as well as the demand curve if you consider what you said: the law of diminishing returns. As the consumer subsidy increases, demand increases, and at some point the cost/unit of production increases (law of diminishing returns). THIS WOULD CAUSE A SHIFT IN THE SUPPLY CURVE, as producers are less inclined to supply. So there would be two competing elements. Of course, consumer demand (shift in D-curve) would outweight increased costs per unit (shift in S-curve) by a huge margin, but the process is there.

As CRGreathouse indicated, you are confusing a movement along the supply curve with a shift of the supply curve, and you are half-correct when you say the only thing that causes a movement along the supply curve is a change in price* (in your response to CRG, quoting wikipedia). More importantly, what you have postulated is, at best, a second-order effect, sort of like "Reaganite" supply-side economics (aggregate supply "will eventually" shift to the right in response to lower taxes). But the OP is about the first-order effects; it's a simple microeconomic question that does not require the macroeconomic analysis that you have attempted.

To focus on the microeconomics, the analysis is the same whether it's the demand curve or the supply curve "doing the shifting." A subsidy is like a reverse tax (negative tax), so subsidy analysis is qualitatively identical to tax analysis. Starting with a positive tax, this graph indicates that there is a pre-tax equilibrium with one price, and a post-tax equilibrium with two prices -- the difference between the two prices accrues to the taxing authority ("the difference belongs to the government"). You can represent the post-tax equilibrium either by shifting the demand curve along the supply curve down, to P_p, or by shifting the supply curve along the demand curve up, to P_c, and the results of the analysis will be the same regardless of which graphical representation is used. In essence that's what CRGreathouse was pointing to by indicating that the [first-order] result of a subsidy (or, for that matter, a tax) is a shift in one of the curves which corresponds to a movement along the other curve.

For a negative tax (that is, a subsidy), one would shift the demand up (consumer subsidy), or the supply down (producer subsidy), while the other curve does not shift.

ALSO, the question asked the consequences of this subsidy to industry. You should talk about how perhaps, if it was an oligopolistic industry, new players would flood into the industry resulting from increased demand and the market may actually become monopolistic or perfect-competition in its tendencies.

You could then talk about future potential consequences of this if the subsidy was removed, and how the industry would be forced back to equilibrium; i.e. all excess firms will die out.

You could then talk about how, post-subsidy, the amount of firms left over actually EXCEEDS the amount of firms in the initial market, EVEN IF THE POST-SUBSIDY DEMAND IS THE SAME SIZE AS THE PRE-SUBSIDY DEMAND. This is because these extra firms have overcome all natural barries to entry that was stopping perfect competition in the original market!

Here you are confusing short-run with the long run. This is a short-run analysis. The (short-run) supply curve incorporates the productive capacity of all the firms in the market, or the industry. The picture that the OP provided indicates that the firms existing in the industry are able to meet the increased demand, although at a higher price. The higher price is the "cost" of bringing in higher-cost firms (or facilities, plants, machines) that were not being used before the demand shift. But that does not mean there is new firms entering; what's being used is existing "excess" capacity that can start producing at short notice.

I will not go into long-run analysis here, only point out that more firms entering the market in response to a demand increase is a non-sequitur; there is simply not enough information to decide whether there is going to be entry or exit into this industry, with or without the subsidy. For example, we don't know anything about firms' profits, or their fixed or average costs.
_________________________________
*That's because the supply curve is the graphical representation of the marginal cost of supplying a given quantity -- so, when the price rises along a supply curve, more productive capacity is brought in-line at a higher cost because consumers are demanding it. On a supply curve, "price" is really the measure of (and remuneration for) the supply cost. Just like on a demand curve "price" is the measure of (and "opportunity cost" of) consumer utility.

 

[brainstorm]

a consumer subsidy would only shift the demand curve on products that are scarce due to budgeting. Staple necessities like bread, rice, pasta, etc. would probably not inflate due to such a subsidy. Things inflate where consumer fiscal discipline relaxes.

 

[EnumaElish]

a consumer subsidy would only shift the demand curve on products that are scarce due to budgeting. Staple necessities like bread, rice, pasta, etc. would probably not inflate due to such a subsidy. Things inflate where consumer fiscal discipline relaxes.

A subsidy will always shift up a demand curve (by definition of a demand curve); the only exception is when the demand curve is vertical, which means that consumer price is completely irrelevant to consumers' purchase decisions, for any consumer and all consumers. It's for the same reason that a consumer tax will shift the demand curve in.

 

[brainstorm]

A subsidy will always shift up a demand curve (by definition of a demand curve); the only exception is when the demand curve is vertical, which means that consumer price is completely irrelevant to consumers' purchase decisions, for any consumer and all consumers. It's for the same reason that a consumer tax will shift the demand curve in.

But are you taking into account the fact that the subsidy money would be spent differently depending on the needs and wants of different products? Let's say someone always buys iceberg lettuce instead of Romaine because they want to save money for other things. Now you give them a subsidy and they decide to go ahead and buy Romaine. In that case the demand for iceberg shifts down, b/c the amount consumers are willing to buy at a given price is less. The demand for Romaine, however, shifts up b/c the quantity they are willing to buy at that price has increased. This could drive the price up, if Romaine became relatively scarce as a result of increased consumption - but that could also promote more growers to grow more Romaine, which would increase the quantity available and potentially result in more supply-side competition, which could eventually lower the price.

 

[EnumaElish]

But are you taking into account the fact that the subsidy money would be spent differently depending on the needs and wants of different products? Let's say someone always buys iceberg lettuce instead of Romaine because they want to save money for other things. Now you give them a subsidy and they decide to go ahead and buy Romaine. In that case the demand for iceberg shifts down, b/c the amount consumers are willing to buy at a given price is less. The demand for Romaine, however, shifts up b/c the quantity they are willing to buy at that price has increased. This could drive the price up, if Romaine became relatively scarce as a result of increased consumption - but that could also promote more growers to grow more Romaine, which would increase the quantity available and potentially result in more supply-side competition, which could eventually lower the price.

That's a relevant point so thanks for bringing it up. Let's say we are looking at a demand & supply graph for iceberg lettuce. The "subsidy" that I am thinking about is a specific subsidy for buying iceberg lettuce, not Romaine, not any lettuce nor some other commodity. It's as if the government is handing out supermarket coupons, and on each coupon there is a computer-readable "scanner" code for "iceberg lettuce."

Alternatively, if what I have in mind is a "lettuce subsidy," applicable to any kind of lettuce, then the graph I study is the demand & supply for all lettuce. In that case, the demand for lettuce shifts up.

As a side note, I am ignoring any income effects, assuming that the subsidy in question is small relative to overall income.

The examples I have provided are different from a general income subsidy (a negative income tax), which can affect different commodities differently, depending on consumer tastes. A similar, but much smaller effect may be present due to the income effect of a specific subsidy, which I am ignoring for the sake of keeping the analysis simple and tractable.

Thanks, again, for clearing that up.

 

[brainstorm]

The funny thing to me is that increasing supply-side competition would have more or less the same effect as a consumer subsidy. Take the lettuce example again. If growers team up with other middlemen than, say, supermarkets and undercut the retail price of lettuce, the supermarkets must also compete to match the price of the farmer's markets or road-side produce stands or whatever they are. Then, if the supermarkets want to take back business from the farmer's markets, they would have to cut their costs, including management wages, share dividends, etc. to undercut the costs of the competition. So, in the case of a consumer subsidy, taxes are taken from the managers, shareholders, etc. and provided to consumers to spend on the lettuce to generate profits. But the same managers and shareholders could provide the subsidy directly by lowering prices.

The funny thing is that since the free market is supposed to do this automatically by fostering maximum competition, so the need for a subsidy comes from the fact that there is insufficient competition. This may not be so much the result of industry collusion as it is the failure of consumers to seek lower prices diligently. Many consumers want the luxury of shopping at profitable and embellished retail outlets, yet they want this to be subsidized instead of working for it on the demand side by rationalizing their consumption choices.