Subsidies can’t make things unaffordable

May 12 2458616

In last week’s post I talked about a supposed benefit of subsidies that almost never materializes. In this week, I’m going to talk about a supposed harm of subsidies that is literally impossible.

The American Enterprise Institute (a libertarian think-tank) has been sending around a graph of price increases over the last 20 years by sector, showing what everyone already intuitively knows: healthcare and education have gotten wildly more expensive, while high-tech products have gotten extremely cheap. Actually I was a surprised how little they found housing prices had increased (enough to make me wonder what metric they are using for housing prices).

They argue that it is government intervention which has created these rising prices:

Blue lines = prices subject to free market forces. Red lines = prices subject to regulatory capture by government.

Along similar lines, Grey Gordon and Aaron Hedlund published a book chapter presenting evidence that student loans and federal subsidies are responsible for increases in college tuition. They are professional economists, so I feel like I ought to take their argument seriously… but it’s really hard to do, because it’s such a silly concept at the most basic level. I could nitpick their assumptions about elasticity of demand and monopoly power, but the whole argument just doesn’t pass the smell test.

Subsidies always make things more affordable for the person being subsidized.

It’s possible for subsidies to create other distortions, and make things more expensive for those who aren’t subsidized. But it’s literally impossible for subsidies to make something unaffordable to the person being subsidized.

That result is absolutely fundamental, and it comes directly from the Law of Supply and Law of Demand.

Subsidies

On this graph, the blue line is the demand curve. The red line is the supply curve. The thick green line is where they intersect, at the competitive equilibrium price. In this case, that equilibrium means we sell 6 units at a price of $3 each.

The thin green lines show what happen if we introduce a subsidy. Here the subsidy is $3. The sticker price can be read off of the supply curve: It will rise to $4. But the actual price paid by consumers is read off the demand curve: It will fall to $1. Total sales will rise to 8 units. The total cost to the government is then 8($3) = $24.

These exact numbers are of course specific to the example I chose. But the overall direction is not.

We can go ahead and draw this with all sorts of different supply and demand curves, and we’ll keep getting the same result.

Here’s one where I didn’t even make the curves linear:

Subsidies_2

In this case, a subsidy of $5.40 raises the sticker price from $6.10 to $11.20, only reducing the price for consumers to $5.80, while increasing the quantity sold from 3.5 to 4.8. The total cost of the subsidy is $25.92. The price effects are very different in magnitude from the previous example, and yet all the directions are exactly the same—and they will continue to be the same, however you draw the curves.

And here’s yet another example:

Subsidies_3

Here, a subsidy of $2.30 raises the sticker price from $4 to $5.30, lowers the cost to consumers to $3, increases the quantity sold from 4 to 7 units, and costs $16.10.

If you’re still not convinced, try drawing some more of the same diagrams yourself. As long as you make the supply curve slope upward and the demand curve slope downward, you’ll keep getting the same results.
A subsidy will always do four things:

  1. Increase the sticker price, benefiting sellers.
  2. Decrease the price that subsidized consumers actually pay, benefiting those consumers.
  3. Increase the quantity sold.
  4. Cost the government money.

The intuition here is quite simple: If I give you free money every time you buy a thing, you’ll buy more of that thing (3) because it costs you less to do so (2). Because you buy more of the thing, the price will go up (1), but not enough to cancel out the reduced cost to you (or else you’d stop). Since I’m giving you free money, that will cost me money (4). This intuition is fully general: It doesn’t matter what kind of product we are talking about, you’re never going to buy less or have to pay more for each one because I gave you free money.

The size of each effect depends upon elasticity of demand and supply, in basically the same way as tax incidence. The more inelastic side of the market is harmed less by the tax and also benefits less from the subsidy. For any given change in quantity, more inelastic markets raise more tax revenue and cost more subsidy spending.

If we allow elasticities of demand or supply to be zero or infinite (which is almost never the case in real life), then some of these effects might be zero. But they will never go the opposite direction, not as long as the supply curve slopes upward and the demand curve slopes downward.

I suspect that education has relatively inelastic demand and relatively elastic supply, which would mean that the subsidies are actually largely felt by the consumer, not the seller. But that’s actually a legitimate economic question: I might be overestimating the elasticity of supply.

There are other legitimate economic questions here as well, such as how much benefit we get out of a given subsidy versus other ways we might spend that money, and how subsidies may hurt others in the same market who aren’t subsidized.

What is not a legitimate question is the one that these libertarian think-tanks seem to be asking, which is “If you give people money, will they end up with less stuff?” No, they won’t. That’s not how any of this works.

And I’m pretty sure the people in these think-tanks are smart enough to know that. They might be blinded by their anti-government ideology, but I actually suspect it’s more sinister than that: They know that what they are saying isn’t true, but they consider it a “noble lie”: A falsehood told to the common folk in the service of a higher good.

They are clever enough to not simply state the lie outright, but instead imply it through misleading presentation of real facts. Yes, it’s true that subsidies will raise the sticker price—so they can say that this was all they were asserting. But not only is that obvious and trivial: It wouldn’t even support the argument they are obviously trying to make. Nobody cares about the sticker price. They care about what people actually pay. And a subsidy, by construction, as a law of economics, cannot possibly increase the amount paid by the buyer who is subsidized.

What they obviously want you to think is that the reason healthcare and education are so unaffordable is because the government has been subsidizing them. But this is basically the opposite of the truth: These things became unaffordable for various reasons, and the government stepped in to subsidize them in order to stop the bleeding. Is that a permanent solution? No, it’s not. But it does actually help keep them affordable for the time being—and it could not have done otherwise. There’s simply no way to give someone free money and make them poorer. (Of course, fully socialized healthcare and education might be permanent solutions, so if the libertarians aren’t careful what they wish for….)

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