Subsidies

What is a subsidy? A subsidy is really just a negative or reverse tax. Instead of collecting money in the form of a tax, the government gives money to consumer or producers. In this video, we look at the subsidy wedge and who benefits the most from different subsidies.

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

We're going to move quite quickly

because if you've understood
the material on taxes,

the material on subsidies
should follow pretty easily.

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

this is going to be
even more mysterious.

So make sure you understand taxes

before we move on to subsidies.

Here we go.

Now a subsidy is really
just a negative or a reverse tax.

Instead of taking money,

the government gives money
to consumers or producers.

Now here are some
economic truths about subsidy.

Who gets the subsidy
does not depend

on who receives the check
from the government.

Once again,
the legal incidence of the subsidy --

who gets the check --

is not the same
as the economic incidence.

That should always
already be familiar

from our discussion of taxes.

Similarly, who benefits from the subsidy

does depend

on the relative elasticities
of demand and supply --

again, just as with taxes.

Finally, subsidies must
be paid for by taxpayers,

so instead of revenues,

there's a cost to a subsidy.

And they create
an inefficient increase in trade,

also called a deadweight loss.

Let's take a look in more detail.

Okay, we have a lot to cover
in this diagram

so put on your thinking hats.

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

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

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

that the legal incidence
of who gets the subsidy

does not influence
the economic incidence.

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

which is that a subsidy drives a wedge

between the price received by sellers
and the price paid by the buyers.

The only difference from the tax

is that the price received
by sellers with the subsidy

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

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

except we're going
to drive the wedge

into the diagram
from the right hand side.

So now consider
the height of this wedge --

let's suppose that's a dollar --

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

and the bottom
hits the demand curve.

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

So at the top, at point B,

this tells us the price
received by sellers --

suppose that's $2.40.

The bottom, at point D,

tells us the price
paid by the buyers -- $1.40.

Notice that the price
received by the sellers

has got to be $1 more

than the price paid by the buyers,

the $1 coming from the subsidy.

Notice also the key idea --

it doesn't matter
whether the suppliers

receive the check
from the government,

or whether the buyers receive
the check from the government.

On net, when all is said and done,

the sellers will receive
$2.40 per unit,

and the buyers
will pay $1.40 per unit.

By comparing
with the free market price,

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

In this case,

both the suppliers and demanders
get some of the gain.

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

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

The buyers used to pay $2 --

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

Who gets the gain

is going to depend upon

the relative elasticities
of supply and demand

and you want
to convince yourself of that

by drawing some more
diagrams like this,

but draw them with
a really inelastic supply curve.

See what happens.

Then draw it with a more
elastic supply curve,

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

See what happens --
so test out different things.

Next, a tax creates
revenues for the government --

a subsidy creates
costs to the government.

What is the cost?

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

that's given
by the height of the wedge.

What's the quantity
which is subsidized?

Well, it's this quantity right here.

So the total cost
of the subsidy

is $1 times the quantity,

or the subsidy amount
times the quantity,

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

Finally -- got a lot to cover,

but it should all be
fairly standard now --

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

not surprisingly,

is that it increases
the quantity exchanged.

So it increases it from quantity --
no subsidy --

to the quantity with the subsidy.

Now, on these additional units exchanged,

notice what the supply
and demand curve tells us.

It tells us that
on those additional units,

the cost to the suppliers
of supplying those units

exceeds the value
to the demanders of those units.

So, this additional quantity
is creating a waste.

The cost to the suppliers
exceeds the value

of those units to the demanders.

So the subsidy
creates a deadweight loss.

There's too much trade going on,

as opposed to the tax --

where the tax
reduces beneficial trades,

the subsidy increases
wasteful trades.

Okay, take a good look at
this diagram.

Make sure you understand
each part of the diagram,

and we're going to give
some applications

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

But this is really the key idea --

everything in this diagram
right here.

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

It's that elasticity is like escape.

So the more elastic
the demand curve,

the more the demanders
are able to escape the tax.

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

the more able the suppliers
are to escape the tax.

Here I want to give you
a similar intuition

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

And that is,
when you have no elasticity

or when you have
an inelastic curve,

then there's no entry.

No elasticity equals no entry.

And when there's no entry,

that's when you gain
the benefits of the subsidy.

When no one can
come in to take the subsidy,

you get the benefit.

So when there's no elasticity,
no entry,

you get the benefit of the subsidy.

Let's take a look.

Let's redo our tax analysis.

So suppose we have
a fairly elastic demand curve

and a fairly inelastic supply curve,

and here's our tax wedge.

We drive it in the diagram
and what we see

is that the suppliers bear
more of the burden of the tax.

That is, the price to them falls.

They're bearing
the brunt of the tax

because the suppliers
have nowhere else to go.

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

and use it to produce
other goods in the economy.

The supply is relatively fixed,

the resources are most useful
for producing this particular good,

so the suppliers cannot escape.

For the very same reasons,

the suppliers will get most
of the gains of a subsidy.

So here's our subsidy wedge --

we drive it in to the diagram.

We could read off the diagram here
that the price to the suppliers

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

relative to the market price.

So what's going on?

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

but because
the supply curve is inelastic,

we don't see a lot of resources

coming from elsewhere
in the economy

to grab up that subsidy,
to take that subsidy.

The resources
in the rest of the economy

are not good
at producing this type of good,

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

the fixed resources --

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

The price is going to go up

because we don't
have a lot of resources

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

Or we can think about this
from the point of view

of the demanders.

When the demand
is relatively elastic,

they can escape the tax.

But, similarly,
when the demand is elastic,

the demanders from other parts
of the economy

with the substitute goods,

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

They're going to keep the price high

because demanders are going to
stop consuming the substitute good,

and they're instead
going to move into this market

to consume this good.

And because you get
all of these demanders

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

the price doesn't fall very much.

Okay, once again,
play around with this.

Draw some demand and supply curves,

put in a tax wedge,
put in a subsidy wedge

until this all becomes intuitive.

And remember that,
in the case of subsidies,

no elastic or less elastic
means less entry,

less entry means
more gains to the subsidy --

they get more
of the benefits of the subsidy.

Let's do an application.

Farmers in
California’s Central Valley

get a big water subsidy.

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

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

So who benefits
the most from this subsidy?

Is it the California
cotton suppliers,

or is it the buyers
of California cotton?

Let's think about it this way.

The buyers of California cotton --

what kind of substitutes
do they have?

Are they going to have
an elastic demand

or an inelastic demand?

The buyers of California cotton

are going to have
a very elastic demand, right?

Because they can substitute
cotton grown in Georgia,

they can substitute
cotton grown in Pakistan,

in India, in many
other places in the world.

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

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

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

It's simply going
to induce some buyers

to buy more California cotton

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

On the other hand,
the California cotton suppliers --

they've got a pretty
inelastic supply curve.

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

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

and probably fairly fixed
for growing cotton.

So, the California cotton suppliers

are going to get
most of the benefits

of this subsidy.

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

Instead it's going
to go into the pockets

of the California cotton suppliers,
of the farmers.

Not surprisingly,
it's the farmers in California

who lobby extensively
for this subsidy,

and it's not
the consumers of cotton.

So as we've just shown,

subsidies can often be wasteful.

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

the power of Special
Interest Groups in lobbying

and so forth.

We'll talk more
about that another time.

However,
subsidies can also be useful,

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

understates
the true value of that good.

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

when we come
to talk about externalities,

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

where this should be
fairly intuitive

and that's wage subsidies.

So the next lecture,

we'll look at wage subsidies

for unskilled
or lower-skilled workers

and we'll compare that
with the minimum wage.

Thanks.

- [Narrator]
If you want to test yourself,

click “Practice Questions.”

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

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