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A	B	Subsidy: vertical distance
		between S1 & S2

P	S1	P	S1
P*			S2
P^		P^
	D		D
Q1	Q	Q1	Q
	Q* Q2		Q2
Domestic	imports	Domestic supply
supply

F I G U R E 4 . 1 5 S U P P L Y A N D S U B S I D I E S

4.8.1USING SUBSIDIES – AN EXAMPLE WITH INTERNATIONAL TRADE

By using subsidies, the government transfers some of its revenue (paid to it by various taxpayers) to businesses. This affects the supply curve of the industry receiving the subsidy as shown in the example described in Figure 4.15. In panel A, S1 represents the supply curve of the European bicycle industry, D represents the European demand for bicycles so that P and Q are the equilibrium price and quantity of bicycles bought and sold in Europe.

Foreign bicycle manufacturers decide to sell on the European market but they can produce bicycles profitably for P and consumers are happy to buy at this price. At the lower price, some European producers cannot profitably produce because their costs are too high so they go out of business and European suppliers supply Q1 (which is less than Q ). At the lower price consumers increase their demand from Q to Q2 which means the difference between Q2 and Q1 is made up of bicycles produced by foreign suppliers – imported bicycles.

The European bicycle industry, unhappy at losing some of its market to producers from outside the EU, lobbies the EU for subsidies to protect the EU market from foreign supplies (imports). The EU agrees and offers a subsidy of 40% of the international price P . If P is £180, the subsidy received by each European bicycle manufacturer is £72 per bicycle.

Subsidizing an industry results in a rightward shift of the supply function.

The size or amount of the subsidy per unit of output is the vertical distance between the original and new supply functions. (See S1 and S2 in Figure 4.15B).

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This affects the European supply curve because all producers who were previously willing to supply to the market can now supply more bicycles at each possible price, at no additional cost. Looking at Figure 4.15 panel B, compared to the original supply curve, S1, suppliers who receive the subsidy will supply extra bicycles at each price, which means the post-subsidy supply curve is S2.

With the new supply curve and no change in the demand curve a new equilibrium position arises with equilibrium price of P and equilibrium quantity of Q2. Since the new European supply curve intersects the demand curve at a price of P there is no longer any incentive to purchase from abroad, hence imports fall to zero.

Economists generally consider subsidies to be an inefficient use of society’s resources. To see why this is so, look again at Figure 4.15 panel B. At a price of P on S1 European suppliers wished to supply Q1 bicycles. Once the subsidy is offered, however, this increases to Q2. From the cost-curve perspective this means because of the subsidy, firms’ average cost curves have shifted downwards.

Suppliers who were unable to produce competitively at P prior to the subsidy have been attracted by the subsidy to bring some of their resources into the market. Without the subsidy the resources would be used in some other way and economists consider the best use of resources occurs when people freely react to the prices of products that emerge from markets where demand and supply are set by the market without government intervention.

The use of subsidies as shown here has become increasingly less prevalent for a number of reasons. Take the case where the foreign producers, unhappy at being ‘shut out’ of the European market, would probably complain to their own government who would retaliate by subsidizing some of their industries to keep some European products out of their markets. Such policies are not efficient because the situation where subsidies are paid to different industries in different countries creates artificial prices that provide poor signals within the economic system as to how best resources should be allocated to different uses.

There is also the argument that it is unfair to use subsidies to protect domestic markets and keep foreign products out, especially in the case of poorer countries that are attempting to develop economically via their agricultural and basic manufactured exports. Such countries may be unable to retaliate against subsidies, thus affecting their economic development (this argument is followed up in Chapter 9).

For these reasons industrial subsidies attract a lot of attention internationally and under the agreements signed by countries party to the World Trade Organization (WTO) agreements about the use of subsidies have been reached. WTO rules indicate that any subsidies on exports that distort trade are forbidden and while industry-specific subsidies that harm trade are not allowed either, it is sometimes

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difficult to differentiate between illegal subsidies and permitted practices like providing research assistance and support for taking new environmental technologies on board.

4.8.2ENVIRONMENTAL TAXES – EFFECTS ON PRODUCTION

In the case of some industries that create pollution there is pressure, through the Kyoto Protocol for example, to regulate the amount of pollution created and reduce it where possible. (Named after the city in Japan where the agreement was signed, the Kyoto Protocol set national targets for greenhouse gas emissions.) Governments can influence pollution production by the process of limiting the quantities of pollutants allowed in products or by imposing taxes. The costs of pollution that are not borne by the firms that generate pollution and are external to the transactions that give rise to the pollution in the first instance are an example of what are known as externalities.

Externalities – either positive or negative effects of a transaction by one set of parties on others who did not have a choice and whose interests were not taken into account.

Pollution is an example of a negative externality when producers have no incentive to take account of the pollution that is a by-product of production.

Expenditure on successful research and development may have positive externalities if firms learn the technological advances achieved and can put them into practice.

By imposing taxes on polluting firms, governments force them to take account of the pollution they create. Imposing taxes on producers of pollution increases their costs and pushes their cost curves upwards. The imposition of taxes would have consequences as shown in Figure 4.16.

Figure 4.16 panel A shows the equilibrium position for an industry that produces aerosol deodorants – which use CFC gases (chlorofluorocarbons) that are harmful to the environment due to damage they cause to the ozone layer – which is not legally bound to take the cost of the pollution it creates into account. Figure 4.16 panel B presents the situation for the same industry where the government has decided to tax the producers in an attempt to reduce pollution. The amount of the tax is measured as the vertical distance between S1 and S2.

Because suppliers have to pay tax on every unit they produce, there is a wedge or difference between the price they receive and the revenue they can keep. When

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A		B	Tax: vertical distance		S2
			between S1 and S2
P	S1	P
					S1
		P2
P^		P^
	D			D
	Q		Q1	Q2 Q^	Q
	Q^
F I G U R E 4 . 1 6 S U P P L Y A N D E N V I R O N M E N T A L T A X E S

no tax must be paid (Figure 4.16 panel A), at a price of P suppliers were happy to supply Q in equilibrium. When the tax must be paid and if the market price of the product were P , the producers would receive P less the tax. The reduced revenue received by the suppliers means they no longer have the incentive to supply the same quantity to the market. At the price of P on S2 in Figure 4.16 panel B, suppliers wish to supply Q1. Once a tax must be paid, suppliers wish to supply less output at every price, hence the new supply curve S2.

With the new supply curve and no change to the demand curve, a new equilibrium is the outcome with P2 a higher equilibrium price and Q2 a lower equilibrium quantity. We can see that although the tax is the vertical distance between S1 and S2, the price has not increased by the full value of the tax which means suppliers have not passed on the whole tax to the consumers. The amount of tax paid, or the tax revenue received by the government, is shown by the shaded rectangle in Figure 4.16 panel B, which is equal to the amount of the tax (vertical distance between S1 and S2) multiplied by the amount of goods bought and sold (Q2).

If Q 2 = 27 000 units, P 2 = £50 and the vertical distance between S1 and S2 is £20, the amount of tax paid is £540 000. If Q were 36 000, the decline in output resulting from the tax is 9000 units or 33%. If the amount of pollution is directly related to output, pollution will decline by 33% also.

Taxing a polluting industry results in a leftward shift of the supply curve. A new equilibrium ensures with a lower quantity of output and a higher taxinclusive price.