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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- Today we're going to start looking at
Subsidies. We're going to move quite

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quickly because if you've understood the
material on taxes, the material on

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subsidies should follow pretty easily.
However if you haven't understood the

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material on taxes, this is going to be
even more mysterious. So make sure you

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understand taxes before we move on to
subsidies. Here we go.

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Now a subsidy is really just a negative or
a reverse tax. Instead of taking money, the

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government gives money to consumers or
producers. Now here's some economic trues

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about subsidy. Who get's the subsidy does
not depend on who receives the check from

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the government. Once again the legal
incidents of the subsidy, who gets the

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check is not the same as the economic
incidence. That should always already be

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familiar from our discussion of taxes.
Similarly who benefits from the subsidy

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does depend on the relative elasticities
of demand and supply. Again, just as with

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taxes. Finally, subsidies must be paid for
by tax payers, so instead of revenues

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there's a cost to a subsidy, and they
create an inefficient increase in trade,

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also called a deadweight loss. Let's take
a look at more detail. Okay, we have a lot

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to cover in this diagram so put on your
thinking hats. We begin as usual at the

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market free market equilibrium. Let's say
that's at price of two dollars in this

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quantity. Now I'm not going to go through
the proof that the legal incidence of who

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gets the subsidy does not influence the
economic incidence. Instead I'm going to

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jump right to the key point, which is that
a subsidy drives a wedge between the price

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received by sellers and the
price paid by the buyers.

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The only difference from the tax is that
the price received by sellers with the

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subsidy is going to be more than the price
paid by the buyers. So we can use the same

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wedge analysis that we used before except
we're going to drive the wedge into the

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diagram for the right hand side. So now
consider the height of this wedge, let's

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suppose that's a dollar, and let's drive it
in to the diagram until the top hits the

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supply curve and the bottom hits the
demand curve. This is now going to tell us

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everything we need to know. So at the top
at point B this tells us the price

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received by sellers, suppose that's $2.40.
The bottom at point D tells us the price

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paid by the buyers - $1.40. Notice that the
price received by the sellers has got to

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be one dollar more than the price paid by
the buyers, the one dollar coming from the

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subsidy. Notice also the key idea - it
doesn't matter whether the suppliers

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receive the check from the government, or
whether the buyers receive the check from

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the government. On net, when all is set and
done, the sellers will receive $2.40 per

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unit and the buyers will pay $1.40 per unit.
By comparing with the free market price we

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can see who is getting the relative gain
from the subsidy, in this case both the

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suppliers and demanders gets some of the
gain. So the suppliers used to get two

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dollars per unit now they're getting $2.40,
so they get 40% of the gain. The buyers

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used to pay two dollars, now they're
paying $1.40 so they get 60% of the gain.

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Who gets the gain is going to depend upon
the relative elasticities of supply and

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demand, and you want to convince yourself
of that by drawing some more diagrams like

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this, but draw them with a really inelastic
supply curve. See what happens. Then draw it

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with a more elastic supply curve, a supply
curve which is more elastic than the

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demand curve. See what happens - so test out
different things.

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Next, a tax creates revenues for the
government, a subsidy creates cost to the

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government. What is the cost? Well, notice
that the per unit subsidy is one dollar

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that's given by the height of the wedge.
What's the quantity which is subsidized?

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Well, it's this quantity right here. So
the total cost of the subsidy is one

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dollar times the quantity, or the subsidy
amount times the quantity, so it's given

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by this blue area right here. Finally, got
a lot to cover, but it should all be fairly

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standard now. Notice that what the subsidy
does, another fact to the subsidy, not

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surprisingly as it increases the quantity
exchange. So it increases it from quantity

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no subsidy to the quantity with the
subsidy. Now on these additional units

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exchanged, notice what the supply and
demand curve tells us. It tells us that on

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those additional units, the cost to the
suppliers of supplying those units exceeds

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the value to the demanders of those units.
So this additional quantity is creating a

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waste. The cost to the suppliers exceeds
the value of those units to the demanders.

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So the subsidy creates a deadweight loss.
There's too much trade going on, as opposed

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to the tax, where the tax reduces
beneficial trades, the subsidy increases

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wasteful trades. Okay, take a good look at
this diagram, make sure you understand

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each part of the diagram and we're going
to give some applications and give a few

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more ways at looking at this diagram, but
this is really the key idea - everything in

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this diagram right here.
Do you remember our intuition for who

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bears the burden of a tax? It's that
elasticity is like escape. So the more

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elastic the demand curve, the more the
demanders are able to escape the tax. The

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

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suppliers are to escape the tax. Here I
want to give you a similar intuition and

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way of reminding yourself about what
happens with the subsidy, and that is, when

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you have no elasticity or when you have an
inelastic curve, then there's no entry. No

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elasticity equals no entry and when
there's no entry, that's when you gain the

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benefits of the subsidy. When no one can
come in to take the subsidy, you get the

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benefit. So when there's no elasticity, no
entry, you get the benefit of the subsidy.

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Let's take a look. Let's redo our tax
analysis. So suppose we have a fairly

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elastic demand curve and a fairly
inelastic supply curve, and here's our tax

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wedge we drive it in the diagram and what
we see is that the suppliers bear more of

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the burden of the tax. That is the price
to them falls. They're bearing the brunt of

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the tax because the suppliers have nowhere
else to go. They can't take their

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resources used to produce these good and
use it to produce other goods in the

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economy. The supply is relatively fixed, the
resources are most useful for producing

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this particular good so the suppliers
cannot escape. For the very same reasons,

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the suppliers will get most of the gain of
a subsidy, so here's our subsidy wedge. We

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drive it in to the diagram. We could read
off the diagram here that the price to the

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

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the market price. So what's going on?
Well, what's going on is that we have the

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Subsidy, but because the supply
curve is inelastic,

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we don't see a lot of resources coming
from elsewhere in the economy to grab up

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that subsidy to take that subsidy. The
resources in the rest of the economy are

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not good at producing this type of good,
so it's only the resources which are

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already in this market, the fixed resources,
they're the ones which are going to grab

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up the subsidy. The price is going to go
up because we don't have a lot of

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resources coming from other areas of the
economy to produce this good. Or we can

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think about this from the point of view of
the demanders. When the demand is

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relatively elastic, they can escape the tax.
But, similarly when the demand is elastic,

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the demanders from other parts of the
economy with the substitute goods, they're

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going to come in and grab up that subsidy.
They're going to keep the price high

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because demanders are going to stop
consuming the substitute good, and they're

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instead going to move into this market to
consume this good. And because you get all

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of these demanders from elsewhere in the
economy coming in to buy this good, the

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price doesn't fall very much. Okay, once
again, play around with this. Draw some

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demand and supply curves, put in a tax wedge,
put in a subsidy wedge until this all

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becomes intuitive. And remember that, in
the case of subsidies, no elastic or

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less elastic means less entry, less entry
means more gains to the subsidy - you get

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more of the benefits of the subsidy. Let's
do an application. Farmers in Californias

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Central Valley get a big water subsidy.
They typically pay $20 to $30 an acre-foot

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for water that cost $200 to $500 an acre-foot
to produce. So who benefits the most

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from this subsidy? Is this the
California cotton suppliers, or is it the

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buyers of California cotton?
Let's think about it this way. The buyers

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of California cotton, what kind of
substitutes do they have? Are they going

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to have an elastic demand or an inelastic
demand. The buyers of California cotton

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are going to have a very elastic demand,
right? Because they can substitute cotton

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grown in Georgia, they can substitute
cotton grown in Pakistan, in India, in many

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other places in the world. In fact the
price of cotton is basically set in a

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world market, so if we have a subsidy for
California-cotton suppliers, that's not

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going to push the world price down very
much at all. It's simply going to induce

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some buyers to buy more California cotton
and a little bit less of cotton from

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Pakistan or from India. On the other hand,
the California cotton suppliers, they've

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got a pretty inelastic supply
curve. There's not that much land there to

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

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fairly fixed for growing cotton. So, the
California cotton suppliers are going to

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get most of the benefits of this subsidy.
It's not going to lower the price of pants

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at the Gap. Instead it's going to go into
the pockets of the California cotton

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suppliers, of the farmers. Not surprisingly,
it's the farmers in California who lobby

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extensively for this subsidy, and it's not
the consumers of cotton. So as we've just

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shown, subsidies can often be wasteful,
and one of the reasons that we

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have subsidies is politics, the power of
Special Interest Groups in lobbying and so

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forth. We'll talk more about that another
time. However, subsidies can also be

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

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true value of that good. We'll give
lots of examples of this type of thing

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when we come to talk about externalities,
but before we do that I want to give you

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one more example, where this
should be fairly intuitive and

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that's wage subsidies. So the next lecture
we'll look at wage subsidies for unskilled

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or lower-skilled workers and we'll compare
that with the minimum wage. Thanks.

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- If you want to test yourself,
click Practice Questions

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or if you're ready to move
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