The Truth About Subsidies: Part 1

In a comment by Jeff Mayowitz on one of my most widely read posts on Recycling, he stated that:

 “ I’d argue that businesses cannot grow and prosper without some government subsidies. Government subsidies have helped build our infrastructure, helped maintain our roads, bridges, tunnels, seaports…[etc.]…. and government subsidies are to thank.”

Later in his argument he states that,

“I agree that recycling is far from perfect. But government subsidies have helped improve upon it. In my opinion, it is better to subsidize the recycling industry than to continue to subsidize the oil industry that continues to see record profit. “

I feel it is important to bring up these two points in his comment because subsidies, in general, and its relation to environmental policy are two arguments that I feel are widely misunderstood in society.  First, I disagree with that businesses CANNOT grow and prosper without some government subsidies, because in most cases they can and do.   In order to fully respond however, I am going to explain why and when subsidies are warranted in a three-part series.

The first part of my response is that there are goods that cannot function successfully without government assistance. These are called public goods.  Let me explain.

Public goods are described as goods that are nonexcludable and nonrivalrous.  Anything that falls under a pure public good is best funded through the government.

Nonexcludable means that you cannot exclude someone from using that good.  Fireworks shows are a great example.  If someone charged customers to put on a firework show in your town, some people might pay to sit on the lawn in the designated space, but it would be difficult to charge the consumers who watch from their own backyards or on the street.  There would be a lot of free-riding (benefiting from the good, fireworks, without paying for the good), so it is unlikely that the person putting on the firework show would even do so in the first place.  He would probably lose more money than he could make, because he cannot exclude anyone from watching the fireworks.

The nonrivalrous part of a public good means that each additional individual using the good does not make the good cost more.  To make that clearer, a rivalrous good is one In which providing a greater amount of a good requires either more of that good to be produced or less available for others.  A nonrivalrous good has neither of these.   Watching a fireworks show does not make the cost increase for the other viewers nor does it make the amount of fireworks run out faster. If a good has these two requirements, nonexcludability and non-rivalry, than to provide an efficient level of the good the government must do it and fund it through taxes

A more popular example of a public good is national defense.  If 100 people in a town paid for national defense if an outside intruder was to do harm on the region surrounding the town, then if an intruder came in everyone in the town would likely benefit from the defense being there, even those that did not pay for defense (nonexcludability). Further, national defense is intended to protect a region (or country) and it does not cost more based upon the people living in that land (nonrivalrous). If you assume that national defense is protecting our country, its land, buildings, resources etc. than each additional person living here benefits if that land is protected and does not add to the cost of defense.  Public local protection, however, is rivalrous in that a larger population requires more police, firemen etc. and it being a “public” good becomes a bit weary.  If national defense were privatized and funded through individuals there would be the issue of a free-rider problem and also, there could be competing “U.S. armies”.  There there would be the issue of which army is supreme in dealing with foreign conflicts, which could perhaps create even more conflict.  Further, if I saw my neighbor not paying for national defense while I did, but he still benefited from me paying this creates an incentive for me not to pay in the future and just “free-ride” off of others that willingly pay.  If this idea persists, eventually no one will pay for national defense which would create larger problems for security.

Another great example of a public good is a lighthouse. A popular, but tedious, economic paper on lighthouses as a public good was written by the late Ronald Coase.

 

lighthouse

Private goods, on the other hand, can function without government assistance.  Environmental companies can get seed money from venture capitalists, hire lawyers to comply with EPA restrictions and create a product that people are willing to buy (like solar panels on houses.)  Now, these companies don’t have to exist, but if there is demand for the product and low costs the incentive of profit will drive entrepreneurs to enter this new business.  There is excludability, such that one can pay for these goods and receive it or one can choose not to and not receive it. There is rivalry in that if someone wants a solar panel it costs more to produce and there are finite resources.

In terms of recycling, it is not a public good.  It is excludable in that if I don’t pay for my containers to be compounded and the materials to be reused I don’t recycle. (Assuming we are not forced via taxes like in most cities and states today.) It is rivalrous in that it does cost more if I chose to recycle and it costs more per each person who wants to recycle.

There are numerous other private goods that one can think of: clothing, video games, cable television, restaurants, books, recycling, highways, train services etc.  Companies producing these goods CAN and DO prosper without government assistance.  Only goods that are “public goods” are more efficiently produced, or would even be produced at all, when public funds are used.  These goods are usually funded through taxes and not subsidies, however.

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14 thoughts on “The Truth About Subsidies: Part 1

  1. To your point about private goods, I would further specify that the should exist ONLY without government assistance. If there is no demand for some good, it is correct for the producing firm to move out of the sector or go out of business. In fact, to force the public to buy said goods utilizing the government’s power to tax is immoral, not to mention wasteful.

    • Abir, I think your point about private goods is well taken and would be a great post in and of itself. I was trying to build up the argument for subsidies in general, so I steered clear of the morality of the government telling us what to do and just talk about economic efficiencies. When I talk about infant industries on Thursday there is more of a ‘moral’ argument that people make for government subsidies that I will definitely consider including.

  2. Pingback: More on Recycling | Economics & Institutions
  3. What you’re saying is generally true, but there is more to real life than just economic efficiency. For example the food industry. If American grown say corn was not subsidized it would be grown in say Mexico at a lower cost. Theoretically a good idea, however you would become dependent on them in a sense that they could, after you sold all equipment increase the price drastically. Or use potentially harmful fertilizers that would be forbidden here but are allowed there. My whole point: some subsidies make sense in the real world when they don’t make sense in an economic model.

    • Jan, your point is taken, but a globally-traded commodity like corn may not be the best example of it. If we buy corn on the global market, that does not mean we are dependent on one producer–it simply does not follow. For the type of dependence you describe to arise requires a more specialized product in which only a relatively few producers dominate global trade.

  4. I think you should be careful with absolutes (e.g. “anything that falls under a pure public good is BEST funded through the government.” (emphasis mine)), because many public goods are funded via private channels. In fact, private provision of public goods can approach the efficient level and may be more efficient than government funding when you add in the costs of raising funds (for example, see Lindsey and Dougan’s “Efficiency in the provision of pure public goods by private citizens”).

    Also, what would your response be to someone who argued that recycling is simply a means to provide a public good–namely a clean or unpolluted environment? One can certainly argue that a clean environment is a public good and so to follow your logic from above, perhaps it would be efficient for government entities to have a role in the provision of this good via subsidies.

    • I think you are correct in my misrepresentation of the word BEST. I surely didn’t mean to make it sound the way it did, because public goods can be provided by the private market. Thanks for pointing that out.

      My response to someone who thinks that a ‘clean’ environment is a public good would simply be it is not a public good. One could think of numerous items, agendas or policies that could come into place if we view a clean environment as a public good all due to how we think about the word “clean” and “environment”. It seems as if an enormous amount of items can be deemed as necessary to ensure that things keep getting “clean”, but is there a cleanest? If you imagine that recycling, trash pickup, solar panels, no pollution etc. all contribute to this word, “clean”, I can give you reasons why each one could be excludable and rivalrous, but in sum, can a clean environment be a public good? To me the parts equal the sum and if the parts (i.e. the policies) needed to ensure a clean environment are ones in which the private market can make more efficiently than why should the public be providing these things? There is the infant industry argument that I will make tomorrow that maybe can touch on this a bit.

      Thanks for the post! I appreciate the heads up on the private provision of public goods that I failed to include! Definitely worth mentioning though.

      • Replace environment with “fireworks show” and you could make a lot of the same points arguing that fireworks are not a public good (Shows may keep getting better but is there a best?) Obviously there are a lot of things we can do to ensure a clean environment, and for many of them the costs will outweigh the benefits but that doesn’t make it a private good. If clean is too normative for you, then consider environmental quality. Good, bad, or average, it’s non-rivalrous and non-excludable. Does that necessarily mean that recycling should be subsidized? Of course not, but I still think you’re ignoring the counter arguments by claiming that recycling is a private final good and not an input into a public good

  5. Pingback: The Truth about Subsidies: Part 2 | Economics & Institutions
  6. I agree that environmental quality meets the public goods test of nonrivalry and nonexcludability. To me, the most damning thing in the Cato paper was that it suggested that recycling fails the price mechanism test for whether it is the cheapest means to achieve the goal of environmental quality. If it is more expensive to recycle a plastic bottle than to produce one from virgin materials, I think that suggests that the recycled bottle requires MORE resources to produce than the brand new one. If true, that is pretty damning about recycling, though not environmentalism. This is why I find the infant industries argument interesting. Maybe, it can be claimed, the subsidy is required to help the recycling industry find ways to recycle at lower cost which might change the analysis. I hope to hear “someone” weigh in on that.

  7. Pingback: The Truth About Subsidies: Part 3 | Economics & Institutions
  8. Pingback: A True Free Market Economy | An Inside View

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