Benefit of a Subsidy – Economic vs. Legal Incidence

… a core concept in Economic Analysis and Atlas102

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Concept description

The economic incidence (who receives the benefit) of a subsidy differs from the legal incidence (who receives the cheque from the government) in ways that depend on the relative elasticities of supply and demand.

This can be summarized:

  • The more elastic side of the market will receive a smaller share of the subsidy (smaller benefit)
  • The less elastic (more inelastic) side of the market will receive a greater share of the subsidy (greater benefit)
No elasticity = no entry

Tabarrok suggests that, analogously with the proposition that “elasticity = escape” in thinking about the burden of taxes, the proposition “no elasticity = no entry” can be used to think about who receives the benefit of a subsidy.

NoElasticityNoEntryWhere supply is highly inelastic relative to the demand, other suppliers cannot enter the market to share the subsidy and most of a producer subsidy will stay with the producers. Tabarrok uses the example of cotton farmers in California’s Central Valley who pay $20-$30 per acre foot for water that costs government $200-$500 per acre foot to produce. Question: Who benefits most, California cotton suppliers or California cotton buyers? Answer: The California cotton suppliers because the demand for California cotton is highly elastic since buyers can buy their cotton from anywhere in the world and the water subsidy will not significantly affect the world price of cotton.

Practice questions (from MRU Chapter 4)

From http://www.mruniversity.com/node/186786, accessed 29 April 2016.

  1. Fill in the blanks: When the government subsidizes an activity, resources such as labor, machines, and bank lending will tend to gravitate __________ the activity that is subsidized and will tend to gravitate ___________ activity that is not subsidized.

Source

Alex Tabarrok, Subsidies, Marginal Revolution University, 13-minute video, at http://www.mruniversity.com/courses/principles-economics-microeconomics/subsidies-definition-subsidy-wedge, accessed 29 April 2016.

Atlas topic and subject

Taxes and Subsidies (core topic) in Economic Analysis.

Page created by: Ian Clark, last modified on 29 April 2016.

Image: Minute 0.15 of MRU Video, at http://www.mruniversity.com/courses/principles-economics-microeconomics/subsidies-definition-subsidy-wedge, accessed 29 April 2016.