As it turns out, Ima Hogg has a sister, Ura, who is already a successful watermelon farmer.¹ We want to address the following question, "If a farmer is already making a profit, would a subsidy still lower society's happiness?" Let's take a closer look at Ura's business affairs to get an answer to this question.

Before the watermelon subsidy program went into effect, Ura Hogg was making a nice little profit on her watermelon operation. Like Ima, she had a patch of land behind her house on which she too could grow a 1,000 watermelons. At a market price of $5 per watermelon, this gave her $5,000 in revenues. But Ura is a better shopper than Ima. By buying her materials from low-cost suppliers, Ura finds that she could grow 1,000 watermelons for a total cost of only $4,000. As a result of her hard work and smart business sense, Ura earns $1,000 in profits before receiving any subsidies.

Now consider the effect of the watermelon subsidy program. As the table clearly shows, with an extra $2 per watermelon in subsidies, Ura's profits increase to $3,000. What has happened to social happiness? Absolutely nothing. The subsidy hasn't affected social happiness in this case because the subsidy hasn't altered Ura's management of society's resources. Before the subsidy, Ura transferred $4,000 of resources from other activities to the production of 1,000 watermelons. After the subsidy, Ura still transfers $4,000 of resources from other activities to the production of 1,000 watermelons. Resources are allocated the same way before and after the subsidy. SINCE THERE IS NO CHANGE IN THE ALLOCATION OF RESOURCES, THERE IS NO CHANGE IN SOCIETY'S HAPPINESS.

How about the fact that Ura Hogg now makes more money? Again, the transfer of $2,000 in subsidies to Ura Hogg is exactly counterbalanced by the transfer of $2,000 away from other taxpayers who had to foot the bill for this program. It represents a pure wealth transfer that results in no change in society's total happiness.

You should now see that when it comes to subsidies, there are two kinds of watermelons in the world. There are those watermelons that would have been produced before the subsidy, and still get produced after the subsidy (like Ura Hogg's watermelons). And there are those watermelons that would not have been produced before the subsidy, but now get produced because of the subsidy (like Ima Hogg's watermelons). Only the production of the latter kind of watermelons causes a change in society's happiness.

Thus, in analyzing the effect of a particular public policy on society's happiness, we follow the following three-step procedure.

Step 1. We begin by determining how the policy will change the allocation of society's resources. In particular, we ask whether the policy will increase or decrease the quantity of the good directly impacted by the public policy. For example, subsidies lower costs, so production increases. In contrast, taxes increase costs and hence decrease production.

Step 2. Once we determine whether more or less of the good will be produced, we focus on a specific resource transfer that is changed by the public policy. For example, in the case of watermelon subsidies, we look only at those watermelons that would not been produced before the subsidy, but get produced after the subsidy. Further, we don't look at all the affected watermelons. We just choose a representative case. We focus on a typical resource transfer that is altered by the policy.

Step 3. We then construct numbers using the PROFIT TABLE to illustrate how society's happiness is impacted in this particular case.

Having shown it for the representative case, we're finished. For while the numbers might be different for other resource transfers impacted by the policy, the conclusion will always be the same. Thus, our simplistic Profit Table will lead us to the correct conclusion every time. ("Look out cocktail parties, here we come!") The next chapter shows how to use this simple, three-step framework for analyzing public policies involving taxes.

The second step consists of choosing a representative resource transfer affected by the policy. Note that the units between Q₀ and Q₁ are the only resource transfers affected by the public policy. They are the units that wouldn't have been produced before the subsidy, but get produced after the subsidy. Thus, we focus on one of the units between Q₀ and Q₁, call it Q*

The last step consists of representing the resource transfer Q* in the Profit Table. Note that before the subsidy, the supply curve lay above the demand curve at the indicated quantity. We translate this into our Profit Table by showing Revenues as being less than Costs. After the subsidy, the supply curve lies below the demand curve at Q*. This is reflected in the Profit Table by showing that Revenues are now greater than the (subsidized) Costs.

The Profit Table thus represents a resource transfer which lowers society's happiness. Before the subsidy, this resource transfer was unprofitable, and thus a profit-maximizing firm would never undertake it. After the subsidy, this resource transfer becomes profitable, so that the firm is "tricked" into doing something which lowers society's happiness. This captures the essence of the welfare loss associated with the subsidy.