Question

1. Draw a demand and supply model to illustrate the effects of a government subsidy paid to milk farmers for every litre of milk they sell. (Chapter 6 of the text can help you with this). Assume that demand for milk is relatively inelastic, while the supply of milk is relatively elastic. Illustrate and explain what happens to the price farmers receive, the price buyers pay, the cost to government and the quantity of milk sold. (Do not use actual numbers, but rather symbols such as P1 , Q1 etc. Make sure you define what the symbols you use represent.)

2. Who benefits most from the subsidy in this scenario – milk producers or milk consumers? Explain your answer.

c) Identify the dead weight loss of the milk subsidy on your diagram, and explain why it arises

Answer 1

(a)

In following graph, D0 and S0 are initial demand and supply curves (D0 being steeper than S0 since demand is more inelastic than supply), intersecting at point A with initial price P0 and quantity Q1. The subsidy effectively lowers the production cost of farmers, increasing supply and shifting supply curve rightward to S1, intersecting D0 at point B. Price paid by buyers is P1, price received by farmers is P2, unit subsidy is (P2 - P1) and quantity is higher at Q1. Cost to government equals area P1BCP2.

(b)

Since demand is inelastic relative to supply, the subsidy benefits the consumers more than the farmers, since share of subsidy enjoyed by consumers (= P0 - P1) is higher than the share of subsidy enjoyed by the farmers (= P2 - P0).

(c)

Deadweight loss arises since the subsidy leads to a higher-than-optimal quantity of milk being produced, since post-subsidy quantity is higher than free-market quantity. This leads to social inefficiency loss, measured by area ABC.