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♪ [music] ♪

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- [Prof. Alex Tabarrok] Today we're
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
the material on taxes,

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the material on subsidies
should follow pretty easily.

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

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this is going to be
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
just a negative or a reverse tax.

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Instead of taking money,

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the government gives money
to consumers or producers.

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Now here are some
economic truths about subsidy.

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Who gets the subsidy
does not depend

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on who receives the check
from the government.

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Once again,
the legal incidence of the subsidy --

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who gets the check --

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is not the same
as the economic incidence.

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That should always
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
of demand and supply --

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again, just as with taxes.

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Finally, subsidies must
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
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
in this diagram

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so put on your thinking hats.

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

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

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

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that the legal incidence
of who gets the subsidy

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does not influence
the economic incidence.

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Instead, I'm going
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
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
by sellers with the subsidy

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

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So we can use the same
wedge analysis that we used before

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except we're going
to drive the wedge

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into the diagram
from the right hand side.

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So now consider
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
until the top hits the supply curve

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and the bottom
hits the demand curve.

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This is now going to tell us
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
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
paid by the buyers -- $1.40.

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Notice that the price
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
whether the suppliers

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receive the check
from the government,

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or whether the buyers receive
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
$2.40 per unit,

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and the buyers
will pay $1.40 per unit.

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By comparing
with the free market price,

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

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In this case,

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both the suppliers and demanders
get some of the gain.

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So the suppliers
used to get $2 per unit --

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now they're getting $2.40,
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,
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
of supply and demand

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and you want
to convince yourself of that

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by drawing some more
diagrams like this,

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but draw them with
a really inelastic supply curve.

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See what happens.

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Then draw it with a more
elastic supply curve,

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a supply curve which is more
elastic than the demand curve.

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See what happens --
so test out different things.

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Next, a tax creates
revenues for the government --

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a subsidy creates
costs to the government.

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What is the cost?

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

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that's given
by the height of the wedge.

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What's the quantity
which is subsidized?

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Well, it's this quantity right here.

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So the total cost
of the subsidy

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is $1 times the quantity,

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or the subsidy amount
times the quantity,

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

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Finally -- got a lot to cover,

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but it should all be
fairly standard now --

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notice that what the subsidy does,
another effect of the subsidy,

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not surprisingly,

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is that it increases
the quantity exchanged.

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So it increases it from quantity --
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
and demand curve tells us.

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It tells us that
on those additional units,

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the cost to the suppliers
of supplying those units

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exceeds the value
to the demanders of those units.

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So, this additional quantity
is creating a waste.

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The cost to the suppliers
exceeds the value

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of those units to the demanders.

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So the subsidy
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
reduces beneficial trades,

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the subsidy increases
wasteful trades.

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Okay, take a good look at
this diagram.

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Make sure you understand
each part of the diagram,

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and we're going to give
some applications

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

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But this is really the key idea --

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everything in this diagram
right here.

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Do you remember our intuition
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
the demand curve,

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the more the demanders
are able to escape the tax.

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The more elastic the supply curve
relative to the demand curve,

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the more able the suppliers
are to escape the tax.

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Here I want to give you
a similar intuition

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

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And that is,
when you have no elasticity

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or when you have
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
the benefits of the subsidy.

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When no one can
come in to take the subsidy,

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you get the benefit.

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So when there's no elasticity,
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
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
and what we see

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is that the suppliers bear
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
the brunt of the tax

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because the suppliers
have nowhere else to go.

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

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and use it to produce
other goods in the economy.

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The supply is relatively fixed,

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the resources are most useful
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
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
that the price to the suppliers

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is going to rise much more
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
is that we have this subsidy,

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but because
the supply curve is inelastic,

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we don't see a lot of resources

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coming from elsewhere
in the economy

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to grab up that subsidy,
to take that subsidy.

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The resources
in the rest of the economy

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are not good
at producing this type of good,

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

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the fixed resources --

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they're the ones which
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
have a lot of resources

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

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Or we can think about this
from the point of view

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of the demanders.

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When the demand
is relatively elastic,

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they can escape the tax.

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But, similarly,
when the demand is elastic,

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the demanders from other parts
of the economy

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with the substitute goods,

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they're going to come in
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
stop consuming the substitute good,

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and they're instead
going to move into this market

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to consume this good.

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And because you get
all of these demanders

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from elsewhere in the economy
coming in to buy this good,

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the price doesn't fall very much.

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Okay, once again,
play around with this.

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Draw some demand and supply curves,

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put in a tax wedge,
put in a subsidy wedge

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until this all becomes intuitive.

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And remember that,
in the case of subsidies,

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no elastic or less elastic
means less entry,

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less entry means
more gains to the subsidy --

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they get more
of the benefits of the subsidy.

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Let's do an application.

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Farmers in
California’s Central Valley

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get a big water subsidy.

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

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

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So who benefits
the most from this subsidy?

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Is it the California
cotton suppliers,

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or is it the buyers
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
do they have?

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Are they going to have
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
a very elastic demand, right?

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Because they can substitute
cotton grown in Georgia,

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they can substitute
cotton grown in Pakistan,

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in India, in many
other places in the world.

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

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

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

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It's simply going
to induce some buyers

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to buy more California cotton

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

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On the other hand,
the California cotton suppliers --

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they've got a pretty
inelastic supply curve.

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

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

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and probably fairly fixed
for growing cotton.

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So, the California cotton suppliers

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are going to get
most of the benefits

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of this subsidy.

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

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Instead it's going
to go into the pockets

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of the California cotton suppliers,
of the farmers.

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Not surprisingly,
it's the farmers in California

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who lobby extensively
for this subsidy,

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and it's not
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
we have subsidies is politics --

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the power of Special
Interest Groups in lobbying

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and so forth.

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We'll talk more
about that another time.

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However,
subsidies can also be useful,

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

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understates
the true value of that good.

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We'll give lots of examples
of this type of thing

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when we come
to talk about externalities,

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

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00:12:04,010 --> 00:12:05,990
where this should be
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
or lower-skilled workers

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and we'll compare that
with the minimum wage.

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Thanks.

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- [Narrator]
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,
just click “Next Video.”

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♪ [music] ♪