The increase in the consumer price reduces domestic demand to D 2 . When a production subsidy is imposed the effective supply curve shifts to S' . The subsidy does not affect the consumers' price which remains at P 2 because of the consumption tax. The combined welfare effects of the production subsidy and consumption tax are shown in the Table below. The letters refer to the area in the previous graph.
Red letters indicate losses while black letters indicate gains.
Consumers suffer a loss in surplus because the price they pay rises by the amount of the consumption tax. Notice that the consumer surplus change is read off of the original demand curve, not the effective demand curve. Producers gain in terms of producer surplus. The production subsidy raises the price producers receive by the amount of the subsidy, which in turn stimulates an increase in output. The government receives tax revenue from the consumption tax but must pay out money for the production subsidy.