- A subsidy is a grant from the government to a producer to lower the costs of production, in order to encourage the production or consumption of a good or service.
- The key impact of subsidies is that they can correct market failure by encouraging the consumption and production of merit goods. E.g. teaching subsidies, as education is a merit good but is underprovided in certain subjects.
- For producers, subsidies lower the costs of production because they enable firms to purchase more efficient production methods or buy in bulk enabling them to achieve economies of scale (or just cover some of their costs). Therefore, they can sell at lower prices and produce in higher quantities.
- For consumers, the effect of subsidies is lower prices leading to higher levels of disposable income which can be used elsewhere.
- However, there is an opportunity cost to the government. This is because the money used on the subsidy could have had other uses.