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

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's some economic trues

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

the government. Once again the legal
incidents 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 tax payers, 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 at 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 in 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 for 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 one dollar more than the price paid by
the buyers, the one dollar 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 set 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 gets some of the
gain. So the suppliers used to get two

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

used to pay two dollars, 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 cost to the

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

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 one

dollar 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 fact to the subsidy, not

surprisingly as it increases the quantity
exchange. 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 at 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 these 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 gain 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 the

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 - you get

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

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

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

from this subsidy? Is this 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.

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