22 March 2009

Cost And Subsidy

Indian government subsidies cooking gas (LPG) by almost 50%. Most of us hate subsidies given to others, but would we agree for the cooking gas subsidy to be lifted off? Most wouldn't. And, the irony of the situation is, many would not realize that whether the subsidy is given or not, our individual expenses on an average would not change.

First and foremost to understand is "Government revenue-expense is a zero-sum game". Means, it does not make money. What actually happens is government taxes you, so you become poorer and cannot afford, and since you cannot afford, it subsidises the cost, to make it affordable.  That sounds stupid, doesn't it.

Ofcourse, the government knows this too. But the reason it seems to work is,  government taxes a lot from a few people, but subsidises a little to a lot of us.  This only seems to work, but in reality, it doesn't

Cost of an item is the market valuation of a good's value. An apple costs 10/- per piece and an banana costs 2/- per piece. It means people prefer an apple 5 times to 1 banana. You may talk about cost of production, supply, transport etc. But, the fundamental economic theory is that "Price discounts everything".

Hypothetically, lets say our government, on the behest of some nutritional experts, decides that apples are more beneficial to the population, and have to be subsidized. Every apple from now on will cost only Rs.2/-. The 8/- will be borne by the government.  That doesn't effect anything that causes the price (like cost of production, supply etc), which means people would still value apple 5 times to 1 banana. Since apples have become cheap, everybody buys apples and bananas lose demand and its price slips to 1/5 times that of an apple, i.e 0.40 ps.  This essentially means the currency has depreciated. The fact is government action did nothing but change the value of currency. The relative prices of commodities remain the same.

The above example is over-simplification. It assumes a lot, and hence the not-so-real treatment. In real life,  currency doesn't always get depreciated.  It usually gets appreciated., i.e it results in inflation. Subsidy in one item usually means lower demand of alternatives and hence lower production in them. Such an economy  is producing/choosing a costlier item in preference to cheaper alternatives. This results in value of currency adjusting to accommodate this anamoly.

All the government achieves due to its noble intention of subsidy is changing the math from 1:2 to 3:6.

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