Widgets are produced by a constant-cost industry. Suppose the government decides

Question

Widgets are produced by a constant-cost industry. Suppose the government decides to institute an annual subsidy of $8,000 per year to every firm that produces widgets. 36. a. Explain why, in the long run, each firm's producer surplus must fall by $8,000 b. Suppose the subsidy causes the price of widgets to fall by $1. With the subsidy in place, does each firm produce more than, fewer than, or exactly 8,000 widgets a year? c. Suppose the government replaces the per-firm subsidy with a per-widget subsidy of $1 per widget produced. In the long run, is this change good or bad for consumers? Is it good or bad for producers? (Hint: Remember the zero-profit condition!) Is it good or bad for taxpayers? Is it good or bad according to the efficiency criterion?

Explanation / Answer

a) here the firm has constant average and marginal cost such that AC=MC. so the ACand MC curve will coincide and will be horizontal.so with an annual subsidy of 8000 AC curve will shift downward firm will increase supply. therefore in equilibrium price will fall and aggregate quantity increases. quantity increase to the point where the firm has to break even.so producer surplus will fall but the government is compensating for the fall so net producer surplus remains unchanged.it will lead to less than 8000 widgets per year because of production distortion.

c) as I said in second part per unit subsidy will be suboptimal as compared to lump sum subsidy due to production or consumption distortion. neither the producer nor the consumer will be able to get the full welfare effect of subsidy so total surplus obtained from the (b) case will be less than that from (a) part with a lump sum subsidy. so some of the resources of the taxpayers will be wasted which will not accrue either to producer nor consumer.

b) with a subsidy of $1 for each unit then Marginal revenue and average revenue fall so will increase production but the increase will be less as compared to the first case as there will be production distortions and the quantity will not be produced and consumption distortion as producers will not get the full benefits of subsidy.

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