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- [Prof. Alex Tabarrok] Today we're[br]going to start looking at subsidies.

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We're going to move quite quickly

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because if you've understood[br]the material on taxes,

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the material on subsidies[br]should follow pretty easily.

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However, if you haven't[br]understood the material on taxes,

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this is going to be[br]even more mysterious.

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So make sure you understand taxes

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before we move on to subsidies.

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Here we go.

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Now a subsidy is really[br]just a negative or a reverse tax.

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Instead of taking money,

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the government gives money[br]to consumers or producers.

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Now here are some[br]economic truths about subsidy.

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Who gets the subsidy[br]does not depend

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on who receives the check[br]from the government.

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Once again,[br]the legal incidence of the subsidy --

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who gets the check --

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is not the same[br]as the economic incidence.

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That should always[br]already be familiar

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from our discussion of taxes.

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Similarly, who benefits from the subsidy

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does depend

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on the relative elasticities[br]of demand and supply --

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again, just as with taxes.

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Finally, subsidies must[br]be paid for by taxpayers,

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so instead of revenues,

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there's a cost to a subsidy.

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And they create[br]an inefficient increase in trade,

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also called a deadweight loss.

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Let's take a look in more detail.

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Okay, we have a lot to cover[br]in this diagram

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so put on your thinking hats.

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We begin as usual at the Market --[br]free market equilibrium.

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Let's say that's at price[br]of two dollars and this quantity.

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Now, I'm not going[br]to go through the proof

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that the legal incidence[br]of who gets the subsidy

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does not influence[br]the economic incidence.

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Instead, I'm going[br]to jump right to the key point,

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which is that a subsidy drives a wedge

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between the price received by sellers[br]and the price paid by the buyers.

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The only difference from the tax

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is that the price received[br]by sellers with the subsidy

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is going to be more[br]than the price paid by the buyers.

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So we can use the same[br]wedge analysis that we used before

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except we're going[br]to drive the wedge

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into the diagram[br]from the right hand side.

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So now consider[br]the height of this wedge --

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let's suppose that's a dollar --

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and let's drive it in to the diagram[br]until the top hits the supply curve

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and the bottom[br]hits the demand curve.

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This is now going to tell us[br]everything we need to know.

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So at the top, at point B,

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this tells us the price[br]received by sellers --

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suppose that's $2.40.

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The bottom, at point D,

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tells us the price[br]paid by the buyers -- $1.40.

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Notice that the price[br]received by the sellers

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has got to be $1 more

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than the price paid by the buyers,

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the $1 coming from the subsidy.

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Notice also the key idea --

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it doesn't matter[br]whether the suppliers

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receive the check[br]from the government,

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or whether the buyers receive[br]the check from the government.

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On net, when all is said and done,

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the sellers will receive[br]$2.40 per unit,

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and the buyers[br]will pay $1.40 per unit.

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By comparing[br]with the free market price,

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we can see who is getting[br]the relative gain from the subsidy.

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In this case,

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both the suppliers and demanders[br]get some of the gain.

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So the suppliers[br]used to get $2 per unit --

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now they're getting $2.40,[br]so they get 40% of the gain.

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The buyers used to pay $2 --

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now they're paying $1.40,[br]so they get 60% of the gain.

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Who gets the gain

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is going to depend upon

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the relative elasticities[br]of supply and demand

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and you want[br]to convince yourself of that

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by drawing some more[br]diagrams like this,

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but draw them with[br]a really inelastic supply curve.

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See what happens.

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Then draw it with a more[br]elastic supply curve,

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a supply curve which is more[br]elastic than the demand curve.

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See what happens --[br]so test out different things.

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Next, a tax creates[br]revenues for the government --

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a subsidy creates[br]costs to the government.

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What is the cost?

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Well, notice that[br]the per unit subsidy is $1 --

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that's given[br]by the height of the wedge.

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What's the quantity[br]which is subsidized?

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Well, it's this quantity right here.

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So the total cost[br]of the subsidy

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is $1 times the quantity,

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or the subsidy amount[br]times the quantity,

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so it's given by[br]this blue area right here.

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Finally -- got a lot to cover,

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but it should all be[br]fairly standard now --

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notice that what the subsidy does,[br]another effect of the subsidy,

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not surprisingly,

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is that it increases[br]the quantity exchanged.

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So it increases it from quantity --[br]no subsidy --

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to the quantity with the subsidy.

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Now, on these additional units exchanged,

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notice what the supply[br]and demand curve tells us.

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It tells us that[br]on those additional units,

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the cost to the suppliers[br]of supplying those units

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exceeds the value[br]to the demanders of those units.

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So, this additional quantity[br]is creating a waste.

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The cost to the suppliers[br]exceeds the value

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of those units to the demanders.

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So the subsidy[br]creates a deadweight loss.

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There's too much trade going on,

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as opposed to the tax --

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where the tax[br]reduces beneficial trades,

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the subsidy increases[br]wasteful trades.

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Okay, take a good look at[br]this diagram.

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Make sure you understand[br]each part of the diagram,

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and we're going to give[br]some applications

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and give a few more ways[br]of looking at this diagram.

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But this is really the key idea --

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everything in this diagram[br]right here.

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Do you remember our intuition[br]for who bears the burden of a tax?

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It's that elasticity is like escape.

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So the more elastic[br]the demand curve,

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the more the demanders[br]are able to escape the tax.

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The more elastic the supply curve[br]relative to the demand curve,

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the more able the suppliers[br]are to escape the tax.

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Here I want to give you[br]a similar intuition

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and way of reminding yourself[br]about what happens with the subsidy.

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And that is,[br]when you have no elasticity

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or when you have[br]an inelastic curve,

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then there's no entry.

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No elasticity equals no entry.

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And when there's no entry,

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that's when you gain[br]the benefits of the subsidy.

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When no one can[br]come in to take the subsidy,

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you get the benefit.

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So when there's no elasticity,[br]no entry,

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you get the benefit of the subsidy.

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Let's take a look.

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Let's redo our tax analysis.

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So suppose we have[br]a fairly elastic demand curve

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and a fairly inelastic supply curve,

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and here's our tax wedge.

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We drive it in the diagram[br]and what we see

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is that the suppliers bear[br]more of the burden of the tax.

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That is, the price to them falls.

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They're bearing[br]the brunt of the tax

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because the suppliers[br]have nowhere else to go.

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They can't take their resources[br]used to produce this good

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and use it to produce[br]other goods in the economy.

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The supply is relatively fixed,

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the resources are most useful[br]for producing this particular good,

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so the suppliers cannot escape.

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For the very same reasons,

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the suppliers will get most[br]of the gains of a subsidy.

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So here's our subsidy wedge --

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we drive it in to the diagram.

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We could read off the diagram here[br]that the price to the suppliers

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is going to rise much more[br]than the price to the buyer falls,

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relative to the market price.

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So what's going on?

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Well, what's going on[br]is that we have this subsidy,

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but because[br]the supply curve is inelastic,

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we don't see a lot of resources

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coming from elsewhere[br]in the economy

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to grab up that subsidy,[br]to take that subsidy.

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The resources[br]in the rest of the economy

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are not good[br]at producing this type of good,

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so it's only the resources[br]which are already in this market,

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the fixed resources --

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they're the ones which[br]are going to grab up the subsidy.

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The price is going to go up

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because we don't[br]have a lot of resources

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coming from other areas[br]of the economy to produce this good.

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Or we can think about this[br]from the point of view

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of the demanders.

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When the demand[br]is relatively elastic,

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they can escape the tax.

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But, similarly,[br]when the demand is elastic,

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the demanders from other parts[br]of the economy

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with the substitute goods,

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they're going to come in[br]and grab up that subsidy.

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They're going to keep the price high

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because demanders are going to[br]stop consuming the substitute good,

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and they're instead[br]going to move into this market

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to consume this good.

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And because you get[br]all of these demanders

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from elsewhere in the economy[br]coming in to buy this good,

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the price doesn't fall very much.

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Okay, once again,[br]play around with this.

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Draw some demand and supply curves,

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put in a tax wedge,[br]put in a subsidy wedge

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until this all becomes intuitive.

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And remember that,[br]in the case of subsidies,

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no elastic or less elastic[br]means less entry,

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less entry means[br]more gains to the subsidy --

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they get more[br]of the benefits of the subsidy.

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Let's do an application.

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Farmers in[br]California’s Central Valley

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get a big water subsidy.

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They typically pay $20[br]to $30 an acre-foot for water

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that costs $200 to $500[br]an acre-foot to produce.

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So who benefits[br]the most from this subsidy?

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Is it the California[br]cotton suppliers,

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or is it the buyers[br]of California cotton?

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Let's think about it this way.

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The buyers of California cotton --

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what kind of substitutes[br]do they have?

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Are they going to have[br]an elastic demand

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or an inelastic demand?

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The buyers of California cotton

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are going to have[br]a very elastic demand, right?

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Because they can substitute[br]cotton grown in Georgia,

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they can substitute[br]cotton grown in Pakistan,

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in India, in many[br]other places in the world.

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In fact, the price of cotton[br]is basically set in a world market,

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so if we have a subsidy[br]for California-cotton suppliers,

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that's not going to push the world[br]price down very much at all.

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It's simply going[br]to induce some buyers

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to buy more California cotton

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and a little bit less of cotton[br]from Pakistan or from India.

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On the other hand,[br]the California cotton suppliers --

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they've got a pretty[br]inelastic supply curve.

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There's not that much[br]land there to begin with,

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and it's really pretty fixed[br]for growing agricultural goods,

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and probably fairly fixed[br]for growing cotton.

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So, the California cotton suppliers

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are going to get[br]most of the benefits

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of this subsidy.

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It's not going to lower[br]the price of pants at the Gap.

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Instead it's going[br]to go into the pockets

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of the California cotton suppliers,[br]of the farmers.

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Not surprisingly,[br]it's the farmers in California

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who lobby extensively[br]for this subsidy,

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and it's not[br]the consumers of cotton.

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So as we've just shown,

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subsidies can often be wasteful.

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And one of the reasons that[br]we have subsidies is politics --

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the power of Special[br]Interest Groups in lobbying

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and so forth.

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We'll talk more[br]about that another time.

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However,[br]subsidies can also be useful,

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particularly if there's a reason[br]why the demand for a good

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understates[br]the true value of that good.

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We'll give lots of examples[br]of this type of thing

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when we come[br]to talk about externalities,

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but before we do that I want[br]to give you one more example,

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where this should be[br]fairly intuitive

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and that's wage subsidies.

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So the next lecture,

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we'll look at wage subsidies

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for unskilled[br]or lower-skilled workers

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and we'll compare that[br]with the minimum wage.

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Thanks.

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- [Narrator][br]If you want to test yourself,

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click “Practice Questions.”

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Or, if you're ready to move on,[br]just click “Next Video.”

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