Question

Suppose the government grants a subsidy to domestic producers of an import-competing good. The subsidy tends to result in deadweight losses for the domestic economy in the form of the:

a) Consumer surplus
b) Producer surplus
c) Tax revenue
d) Deadweight loss

Answer 1

A government subsidy to domestic producers of an import-competing good often causes an inefficient market outcome, represented by deadweight loss, which indicates lost economic efficiency and failure to capture all potential gains from trade.

Step-by-step explanation:

When a government grants a subsidy to domestic producers of an import-competing good, it distorts the market equilibrium. This intervention can lead to an inefficient outcome where the total social surplus, which is the sum of consumer surplus and producer surplus, is reduced.

This reduction in total social surplus due to the subsidy represents a deadweight loss. In economic terms, deadweight loss is indicative of an inefficient allocation of resources where potential gains from trade are not fully realized.

When subsidies are in place, the market is prevented from reaching its natural equilibrium, causing losses in efficiency that are termed as deadweight loss.

Specifically, the subsidy can cause a deadweight loss by enabling producers to continue making or selling a good that may not be as valued in a free market, essentially leading to overproduction.

Moreover, the subsidy has to be funded, which typically comes from taxation. These taxes can lead to another form of deadweight loss, given that they alter the behavior of consumers and producers in the market.