Lecture Notes: Subsidies

Introduction to Subsidies

• Definition: A subsidy is a negative or reverse tax where the government gives money to consumers or producers.
• Economic Truths of Subsidy:
  • Economic incidence differs from legal incidence, similar to taxes.
  • Benefits depend on the relative elasticities of demand and supply.
  • Paid for by taxpayers, creating a cost instead of revenue and generating deadweight loss.

Analyzing Subsidy Using Diagrams

• Begin at market-free equilibrium (e.g., price at $2).
• Subsidy Effect:
  • Drives a wedge between seller price and buyer price.
  • Wedge Analysis: Price received by sellers is more than the price paid by buyers.
  • Example: Sellers receive $2.40, buyers pay $1.40, creating a $1 subsidy wedge.
  • Relative gains depend on elasticities: suppliers get 40%, buyers get 60%.
• Cost of Subsidy: Subsidy per unit ($1) times quantity subsidized.
• Impact on Quantity: Increases traded quantity, leading to inefficient trade (deadweight loss).

Elasticity and Subsidy Benefit

• No Elasticity, No Entry Principle: Inelastic curves restrict entry, concentrating subsidy benefits.
• Tax vs. Subsidy Analysis:
  • Tax: Inelastic supply means suppliers bear more burden.
  • Subsidy: Inelastic supply means suppliers gain more benefit.

Application: California Cotton Subsidy

• Subsidy Details:
  • Farmers pay $20-$30 per acre-foot for water costing $200-$500.
  • Elasticity Analysis:
    • Cotton buyers have elastic demand due to global substitutes.
    • Cotton suppliers have inelastic supply due to fixed land resources.
  • Result: Suppliers benefit more, hence lobbying by farmers, not consumers.

Political and Economic Context

• Subsidies often wasteful due to political influences like special interest groups.
• Can be beneficial if demand understates true value (to be discussed further with externalities).

Upcoming Topics

• Next lecture will cover wage subsidies and compare with minimum wage effects.