A subsidy is an amount of money that the government gives to the producers or the suppliers of goods and services in an economy to encourage them either to produce more and to reduce price. Subsidies comes under fiscal policy.
Incidence of subsidies
This means who gets the benefits of subsidies. When the subsidy is given, it encourages the producers to produce more and hence the supply curve shifts to the right. Therefore the price moves down and the quantity demanded and supplied also increases.
However, we have to note that the price reduced will not be as much as the per unit spent by the government on the production. A part of it also will be enjoyed by the producers. Suppose the price of a gallon of milk was $3.5. The government decides to give a subsidy of $1 per gallon. Can we expect the price of milk to come down to $2.5 per gallon? Usually No!
In the diagram, the area in blue is the total benefit gained by the producers due to the subsidy. The area in green shows the total benefits gained by the consumers due to the subsidy.
A subsidy is usually given for the goods which are essential, such as staple food.
Giving subsidies also incurs a dead-weight loss, which is represented by the pink triangle on the 2nd diagram.