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.

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