Having walked up to the water, it's now time for us to take a big drink. In this and the next two chapters, we develop a simple framework for analyzing public policies. How can one, single framework be so useful for analyzing so many different topics? Most every public policy that we can think of involves resource transfers. But resource transfers is what our Grand Unifying Theory of Economics is all about. So buckle up and get ready for an intellectual ride that will turn you into an economic analyst extraordinaire and the absolute hit of any cocktail party. In the previous chapters you learned the pieces of the puzzle. The last three chapters previewed the value of our simple framework by putting those pieces together in a way that allowed us to gain some unconventional insights. Now we tidy things up a bit and present the whole system as an easy, do-it-yourself policy kit.
A large assortment of public policies can be summarized as either SUBSIDY or TAX policies. Let's first consider the effect of a government subsidy program. A subsidy is simply a government payment for production. For whatever reason, governments love to subsidize agricultural products. Honey, milk, wheat, cheese, wool, wine, tobacco--these are just a few of the products that governments pay billions of dollars each year to encourage farmers to produce more than they would on their own. (This then causes such huge increases in production that government then has to pay billions of dollars more each year to encourage farmers to not grow so much, but that's another story). To be concrete, let's consider the effect of a government program to subsidize the production of watermelons.
Suppose Ima Hogg is a pig farmer who happens to have a good patch of unused land behind her house. Early in the spring, Ima gave some thought to raising watermelons in that patch. She figured she could raise 1,000 watermelons a year back there. At a market price of $5 a watermelon, she'd earn revenues of $5,000. Unfortunately, Ima figured that it would cost her $5,500 to grow those watermelons. After mulling it over for some time, Ima decided against going into the watermelon business. That would have been the end of it, except for a chance encounter.
One day while Ima was down at the seed store, she happened to bump into the local agricultural extension agent. He told Ima about a new government program to help watermelon farmers defray their costs. For every watermelon she raised, the government would now pay her $2. That lowers the costs of growing 1,000 watermelons by $2,000. This was wonderful news! Ima quickly figured that with the government subsidy, her watermelon business would now be profitable. Being a woman of action, she got right on it. By the end of the summer, Ima had some of the best looking watermelons in the valley. Thanks to her hard work and the government subsidy program, Ima made a profit of $1,500 on her watermelon business. And society enjoyed 1,000 watermelons that otherwise would not have been available.
Here is a great American success story. The farmer's happy (she made money), the extension agent's happy (he was able to help a friend), watermelon consumers are happy ("Sure been a lot of good watermelons this year."), and the government's happy (the new program seems to be working--more watermelons are being produced). With so many happy people, how could such a program not be good?
Let's analyze this subsidy program with the help of the PROFIT TABLE below.
|
|
Before Subsidy |
After Subsidy |
|
REVENUES: COSTS: PROFITS: |
$5,000 $5,500 -$500 |
$5,000 $5,500 - $2,000 = $3,500 +$1,500 |
Before the watermelon subsidy program, raising watermelons was going to result in a loss of $500. After the program, Ima found she could make a profit of $1,500. Since Ima is making a profit now, and profits are good for society, doesn't the watermelon subsidy program increase society's happiness? DANGER...DANGER...ECONOMIC FALLACY IN THE MAKING!
The fallacy arises because Ima's profits were generated by government intervention (the subsidy), not by consumers buying her goods. Our previous statement that profits measure society's happiness assumed that revenues and costs reported the correct information about the gains and losses in happiness from producing watermelons. In the Before Subsidy column, Ima's costs are the same as society's costs--$5,500. In the After Subsidy column, Ima's costs are now less than society's costs--$3,500 compared with $5,500. As a result of the subsidy, Ima is no longer forced to consider all of the happiness that the inputs could have produced in some other activity.1 The costs she sees on her balance sheet are, from society's perspective, horrible lies. Through no fault of her own, Ima is destroying happiness.
Another way to approach this problem is to ask yourself, what are the only two numbers in the table which represent the gains and losses to society from transferring resources to watermelon production? The answer is: $5,000 and $5,500. In reality, this resource transfer has given consumers $5,000 in additional pleasure from consuming Ima's watermelons. However, other consumers have lost about $5,500 in happiness because Ima withdrew fertilizer, tools, water, etc. from other pleasure-generating activities. So the net effect is a $500 loss in society's happiness. The fact that the government now has kicked in $2,000 doesn't change this reality. It just disguises the real gains and losses from this resource transfer. In this sense, subsidies (and taxes as we shall see), can be thought of as INFORMATION POLLUTION. The bottom line is that the government subsidy "tricked" our firm (Ima Hogg) into transferring resources from a higher valued use to a lower valued one, making society poorer in the process.
But haven't we forgotten something here? Didn't Ima get a check for $2,000? Didn't that make her $2,000 better off? Once again, we make mistakes when we take our eye off the ball, and the ball is always the real gains and losses in consumption that result from any resource transfer. The government handed Ima a check for $2,000, but the government had to take that $2000 from other taxpayers in order to give it to Ima. The government's gift to Ima of $2000 was completely offset by the loss of $2000 suffered by taxpayers who were forced to contribute to the Ima Hogg Watermelon Relief Fund. This is nothing more than a WEALTH TRANSFER. Wealth transfers are always a wash for society.2 While you may think that wealth transfers are unfair or unwise, from the perspective of our simple framework, they make no difference in the overall happiness of society.
OPTIONAL SECTION FOR ECONOMISTS
: The graph below shows a simplified representation of the welfare losses represented in the Profit Table. The subsidy lowers Ima Hogg's marginal costs by $2 per watermelon. Now that her costs have been subsidized, she finds it profitable to produce 1000 watermelons. However, in the absence of the subsidy, marginal costs were above price, which is equal to consumers' willingness to pay.3 That is, the opportunity costs of the resources used to produce the watermelons was greater than the willingness to pay of the consumers receiving the watermelons. The shaded area represents the $500 loss in welfare associated with Ima Hogg's production of 1000 watermelons (note that we have made the simplifying assumption that the fixed costs of production are zero).
Notes
1
Note that we could just as easily have added the subsidy to the farmer's Revenues. This would have given us exactly the same result.2
Barring administrative costs to transferring wealth and possible incentive distortions.3
The observant reader will note that we have ignored the feedback effect of the subsidy on the market price. That is, the subsidy shifts out the market supply curve, lowering the equilibrium price of watermelons. Including this feedback effect would complicate the analysis without changing any of our conclusions. Accordingly, we disregard this effect so as to avoid unduly complicating our analysis.
CONTINUE ON TO THE NEXT CHAPTER