Free Markets IX – Subsidies Cause Waste

Here is a basic principle of economics: subsidies cause waste.

Most commodities have multiple possible uses. Ideally one wants to use them as efficiently as possible. Free markets make that happen. Take the walnut example from the last posting. Walnut wood can be used as firewood, but it has more value made into fine furniture. Both firewood users and furniture makers bid for the wood, but since it is more valuable to the furniture makers they will bid higher, and will get more of the wood. Firewood users will be encouraged by the high price to find some other less-valuable wood for their fireplaces.

One again, it is price signals that produce efficient allocation of commodities across their possible uses.

Now consider subsidies. Subsidies from the government distort the price signal, so that the market no longer allocates goods efficiently to their “best” (most valuable) use. If gasoline is high priced, people are careful in using it, and are encouraged to drive less and buy more fuel-efficient cars.

But if the government subsidizes gas to keep it cheap, then there is less incentive to be careful in using it, and more gets wasted or used for less-than-its-best use. And of course it isn’t really cheaper; it’s just that part of the cost (the subsidized part) is hidden because it comes out of our taxes (used to pay the subsidy) instead of being paid directly at the pump.

Subsidized water is a classic case of subsidies encouraging waste. According to a 1997 report by the University of California, California farmers got about $236 million in water subsidies in that year, making it economically attractive to them to grow water-intensive crops in what is essentially desert ( a really dumb idea, unless like Israel, desert is all you have).

In a free market without subsidies, the cost of scarce California water would rise to its “real” market value, which would be a lot higher. That would give farmers an incentive to use the water more efficiently on crops that were not so water-intensive, to find ways of watering (like drip-watering) that wastes less water, or even perhaps to move their farming to land with more natural rainfall, leaving more of the limited California water for urban areas.

Politicians love subsidies as a way to favor supporters and gain votes, but inevitably the corruption of the market price signals by subsidies makes that market less efficient and results in waste.