The Truth about Subsidies: Part 2

To follow up with part two in my response to the statement that “businesses need some subsidies to grow and prosper” I am going to talk about private and social costs. (Part 1 defined public goods and stated why recycling is not a public good.

Often times people assume that private goods must be public, to help out the greater good.  The arguments follow like this: “I don’t want pollution in the air to kill the trees that help me breathe. The government must make sure trees stay alive.”; “Recycling is environment friendly, so the government should fund this. I want clean water to exist when my children become adults.”  Both of these arguments may give you the warm, fuzzy feeling inside, but alone, these do need qualify the need for public assistance for road building or recycling.  In the absence of being a public good then, what qualifies these goods for public assistance?

The argument for public assistance for goods depends on if there are high transaction costs in defining property rights when there is a difference between private and social cost.  The words I just mentioned are economic words that are typically explained in an Introductory Microeconomics course, so let me briefly review the meanings.

Private costs are those for a producer of a good. These costs include the capital equipment, labor and inputs.  External costs are not reflected on an income statement or in a consumer’s decision.  Social costs are both the private + external costs for a good and service.

Private costs to firms or individuals do not always equate with costs to society for a product or activity.  If the costs do not equate there is said to be an external cost.  An example would be in producing cans of beer at the Anheuser-Busch plant in New Jersey there is a cost to production to firms (aluminum, wheat for beer etc.) and the cost of buying the cans of beer to consumers. Consumers buy beer, because they like it.  However, there is an external cost to society when producing cans (pollution from the production plant enters the air and affects the nearby homes that surround the plant).  Consumers do not take this necessarily into account when buying beer, nor do firms take this into account when producing beer.

When there is an external cost that means the price of the service is too low or there is too much production of the service.  To ensure we, as a society, are producing at an efficient rate of output and at the correct price we must take into account these external costs.

The way to “make up” for these external costs, such as the pollution in nearby neighborhoods or dirty water in a lake due to landfill runoff, would be to define clearer property rights. (If you ever heard of the word externality, it comes directly from ‘external costs’.) Simply, a property right involves the right to use a good, earn income from the good and to transfer the good to others. If someone owned the lake that was being polluted into, easily the lake owner can negotiate with the landfill owner and charge a “fee” for the landfill owner to pollute into the lake. The transaction cost, which in this case is the cost of determining the proper “fee” for polluting into the lake, is relatively low. The lake owner can call the landfill owner and negotiate or go to court to fight the landfill owner for proper monetary damages.  There is no need for the government to intervene by closing down landfills if the private market can come up with an efficient, acceptable solution to both parties.

However, in the case of some environmental problems, such as pollution, it is difficult to determine who has property rights on air.  It is hard to define who has those rights and hard to enforce those rights.  Also, there are high transaction costs in organizing the parties damaged by pollution (i.e. mostly everyone) to negotiate with everyone who pollutes (i.e. most businesses and most people).  It is only in this case that there should be government regulatory solutions.

Needing government regulatory solutions when it is hard to define clear, property rights is not to say that many industries should be subsidized. Often times taxing the polluter to pay damages to those affected, cap and trade solutions, ban on high air emissions etc. may be the most efficient ways to decrease the production or increase the price of the good so that private cost= social cost. Subsidies encourage a greater production of a good, so subsidies are the corrections made if there is a positive externality (positive external costs) or in which social benefit > private benefit.

For example, society values schooling much more than maybe a private individual does.  I may only value getting educated until I am 10, because I never plan on working in a business. I may just want to work on a farm and basic skills taught in the classroom may not be what I feel is important.  However, society may prefer people to get educated until they are 15-18 (this varies per state).  This is because society wants everyone they meet, regardless of job, to have a basic understanding of math, reading, science and our country’s history.  When I walk into the grocery store, I want my checker to be able to understand how to make accurate change, etc.  This is not to say that someone cannot learn this by age 10, but at some age cutoff, society prefers people to be more educated than less.  To make up for this external cost, albeit a positive one, the government funds education.  This helps those with low incomes afford to send their children to school, whereas in the absence of public funding, those who do not have the money may drop out by age 10 or even earlier.

Subsidies can help to equate private benefit to social benefit, but it is not clear that recycling is a good in which private benefit and social benefit are different and thus should be subsidized.  In fact, it is not clear HOW society truly benefits. Scientists claim that recycling saves the earth, but how would the earth really be in absence of forced environmental policies like recycling? We can speculate, but it is hard to truly measure the counterfactual.  Further, the private cost to me to recycle is my taxes (or my penalty for not recycling in some states) and the time spent sorting recycling material.  I am not sure there is much of a social cost to recycling if you assume that we pay taxes for recycling whether people use it properly or not.  It is not clear that there is a divergence in private cost and social cost, so if there is an argument for government assistance, such as subsidies, it must appear on the benefit side.

Nonetheless, even if there is a divergence in benefits such that it requires a subsidy to equate private and social benefit do the benefits truly outweigh the cost of the higher taxes and increased regulation for recycling? I am not sure there is clear consensus that this is true.  Ronald Coase in his article, “The Firm, The Market, and the Law”, writes

The concept of “externality” has come to play a central role in welfare economics, with results which have been wholly unfortunate. There are, without question, effects of their actions on others (and even on themselves) which people making decisions do not take into account. But, as employed today, the term carries with it the connotation that when “externalities” are found, steps should be taken by the government to eliminate them. As already indicated, the only reason individuals and private organizations do not eliminate them is that the gain from doing so would be offset by what would be lost (including the costs of making the arrangements necessary to bring about this result). If with governmental intervention the losses also exceed the gains from eliminating the “externality,” it is obviously desirable that it should remain. (emphasis added)

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One thought on “The Truth about Subsidies: Part 2

  1. Pingback: The Truth About Subsidies: Part 3 | Economics & Institutions

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