Lecture on Subsidies

Introduction

• Subsidies: Concept of negative or reverse tax.
  • Government gives money to consumers or producers.
  • Important to understand taxes as subsidies relate closely.

Economic Truths about Subsidies

• Legal incidence vs. Economic incidence:
  • Who receives the subsidy check is not the same as who benefits economically.
• Dependence on Elasticities:
  • Benefits depend on the relative elasticities of demand and supply.
• Cost to Taxpayers:
  • Subsidies create costs and inefficient increases in trade (deadweight loss).

Diagram Explanation

• Market Equilibrium: Start analysis at free market equilibrium.
• Wedge Analysis:
  • Subsidy drives a wedge between seller price and buyer price.
  • Sellers receive more than buyers pay.
  • Example: Price received by sellers = $2.40; Price paid by buyers = $1.40.
  • Both suppliers and demanders share gains depending on elasticity.

Costs and Effects of Subsidy

• Cost to Government:
  • Determined by per-unit subsidy and quantity subsidized.
  • Illustrates inefficiency and deadweight loss.
• Increase in Quantity Exchanged:
  • Additional units cost more to suppliers than value to demanders.

Elasticity and Subsidy Distribution

• Elasticity Intuition:
  • Inelastic supply/demand leads to more benefit from subsidy.
  • Elastic supply/demand allows avoidance of taxes or less benefit from subsidies.

Application Example: California Water

• Water Subsidy: Farmers pay less for water than production cost.
• Elastic Demand for Cotton:
  • Buyers can substitute with cotton from other regions.
• Inelastic Supply of California Cotton:
  • Limited land; suppliers benefit more from subsidies.

Political Aspect of Subsidies

• Lobbying and Special Interests:
  • Influence of special interests in maintaining subsidies.
• Potential Usefulness:
  • Can be justified if market undervalues a good, e.g., externalities.

Next Steps

• Upcoming topics include wage subsidies and comparison with minimum wage.

Conclusion

• Subsidies increase wasteful trades unlike taxes which reduce trades.

Study Tips

• Practice drawing diagrams to understand elasticities and subsidies.
• Consider political implications and effectiveness of subsidies.