When a production subsidy is imposed the effective supply curve shifts to S' . Because free trade is maintained the domestic market price remains at P FT while demand remains at D 1 . The letters refer to the area in the previous graph. Red letters indicate losses while black letters indicate gains. National Welfare - b Consumers are left unaffected by the subsidy since the domestic price remains the same.
Producers gain in terms of producer surplus.
The subsidy causes the price producers receive to rise to P C , which in turn stimulates an increase in output from S 1 to S 2 . The government, however, must pay the subsidy and that means someone must pay higher taxes to fund the subsidy. Since the cost of the subsidy exceeds the benefits to producers, the net national welfare effect of the production subsidy is negative. Although some segments of the population benefit, there remains a production efficiency loss, given by area b. Foreign prices would remain unchanged and although domestic exports would rise, or imports fall, these changes in trade volumes would have no noticeable impact in the rest of the world.