Question

Explain why subsidizing the purchase of good \(X\) could end up raising the price of good \(X\).

Short answer

A subsidy for good X could end up raising its price as the subsidy can lead to an increase in consumer demand, which could outrun supply. This imbalance may create a temporary shortage, leading to price increases as consumers compete to purchase the good and suppliers seize the opportunity to make more profit.

Step-by-step solution

Understanding the supply-demand model

In a typical supply-demand model, the price of a good is driven by both the buyers (demand) and the sellers (supply). Buyers demand more of the good as its price decreases, while suppliers are willing to produce more goods if the price increases.

Introduction to subsidies

A subsidy is a form of financial aid provided by the government to a certain industry with the purpose of keeping prices of goods and services low and competitive. When the government subsidizes the purchase of good X, it in effect reduces the price of the good for buyers, and this can incentivize increased consumer demand.

Evaluating the effect of increased demand

As the subsidy makes good X cheaper, more consumers are going to demand it. The increased demand could lead to a temporary shortage of the good, as suppliers may struggle to keep up with the new levels of demand.

Impact on the price of good X

The temporary shortage could drive up the price of the good, as consumers compete to purchase it. Suppliers may also increase the price in response to the increased demand, to make more profit. Therefore, a subsidy can end up raising the price of the good, despite the initial intentions of stabilizing the market or reducing the price for consumers.