Homework Question on Effects of Subsidy on Supply
The Federal Government has implemented a policy to subsidize the production of ethanol by paying manufacturers of ethanol a per-unit (e.g., per gallon) production subsidy. [A per-unit subsidy has the opposite effect of the per-unit tax discussed in class] Ethanol is an alternative fuel that can be used in some models of automobiles designed to burn any mix of gasoline up to 85% ethanol (fuel is known as E85, and auto manufacturers label these vehicles as “FlexFuel” and similar names). A primary input in the production of ethanol is corn. For the purposes of this assignment, assume that both the U.S. market for corn and market for ethanol is perfectly competitive.
- Part a: Show geometrically using supply and demand curves the impact of the government per-unit subsidy on the ethanol market. In your graph, denote the distance that reflects the per-unit subsidy amount. Explain the impact of the production subsidy in terms of how it affects producers of ethanol and how it affects the supply curve in the ethanol market. Finally, show what has happened to equilibrium price and quantity in the market for ethanol.
- Part b: Show geometrically using supply and demand curves what impact the change in market price for ethanol has had in the market for E85-burning vehicles. Explain the impact this change in the price of ethanol has had on the customer demand for E85-burning vehicles.
- Part c: The effects of parts (a) and (b) lead to an increase in the overall demand for corn, whereas the overall supply of corn is somewhat fixed. i) Show geometrically using supply and demand curves, what happens to the equilibrium price in the overall market for corn. ii) Show geometrically using supply and demand curves what impact the change in the market price of corn will have in the market for manufactured corn tortillas. Explain the impact of the change in the market price of corn tortillas in terms of how it affects producers of corn tortillas and how it affects the supply curve in the manufactured corn tortilla market. Finally, show what has happened to equilibrium price and quantity in the manufactured corn tortilla market.
Homework Answer on Effects of Subsidy on Supply
Subsidy causes an outward shift of supply, lower equilibrium price and fall in the market price of a commodity as Shown in diagram 1 below. P1 in the graph represents market price before subsidy while P2 indicates market price after subsidy. Q1 indicates quantity demanded before subsidy and Q2 indicate quantities after subsidy. D1 is the demand curve while S1 and S2 indicate quantities supplied before and after subsidy respectively. Region V, W, X, Y, and Z indicates per unit subsidy amount payment by the government for the production of ethanol by manufacturers.
A subsidy on production refers to the grant provided by the government, and it is meant to encourage businesses to add to their supplies. In the case of ethanol production, the subsidy will boost the quantity supplied by the producers and at the same time increase the quantity demanded by the consumers. The federal government policy of subsidizing the production of ethanol is meant to increase on supply and the quantity demanded by the consumers as an alternative to fuel used in automobiles.
The interest could be as a result of ethanol being environmentally friendly as compared with the fuel that its combustion causes air pollution in the environment. As the producers increase the supply of ethanol, the direct effects are reduction in the cost of production, and this allows the suppliers of ethanol to benefit from both the subsidy policy implemented and the lower costs of productions hence maximizing on returns.