Free Trade Model Before Subsidy (Import Model)

In free trade, we see a large area of consumer surplus but a small area of producer surplus. Consumers pay the world price at Pw for a large quantity of goods or services at Q4. The goal of a subsidy is to increase the small green producer surplus, by handing out grants that lower the cost of production, allowing a shift in the supply curve.

Consumers are more favourable to subsidies as it will not change their level of consumer surplus. Consumers, however, need to remember that subsidies are granted from tax revenue and the opportunity cost of tax revenue used in a subsidy.

The Subsidy Model

A subsidy lowers the cost of production for domestic producers, shifting the supply curve from S1 to Ss. As a result, domestic producers receive an increase in producer surplus and an increase in domestic market share from Q1 to Q2.

Consumers maintain their consumer surplus by paying Pw and receiving Q3 quantity of goods and services. The cost of implementing a subsidy is equivalent to the areas of A + B. As area B does not translate into additional producer surplus, it is lost forever and hence, a deadweight loss. As a subsidy causes a deadweight loss, it results in a decrease in total surplus and a net society loss.