Who will really gain from the electric vehicle subsidy?

The government is pressing ahead with introducing subsidies on electric vehicles. However, that comes with unintended consequences, as Newsroom reported last month:

The prices of used electric vehicles have leapt in response to the Government announcing its subsidy of up to $3,450 a car, the country's biggest secondhand car importers say.

Japan-based vehicle buyer Marcus Jones has emailed car importers with a somewhat sardonic update on pricing.

"I thought perhaps you could pass on thanks from the wives and orphans of Japanese EV and Phev owners," he wrote, "who have seen the auction values of their cars rise in the past few days by more or less the precise amount that the New Zealand taxpayer has generously agreed to contribute."

That a subsidy causes prices to rise should come as no surprise to anyone with a good understanding of basic economics. This point is illustrated in the diagram below, which assumes that the subsidy is paid to the buyers of EVs. [*] Without the subsidy, the market is in equilibrium, with a price of P0, and Q0 electric vehicles are traded. Introducing the subsidy, paid to the buyer, is represented by a new curve D+subsidy, which sits above the demand curve. It acts like an increase in demand, and as a result the price that producers receive for an electric vehicle increases to PP. The buyers pay that price, then receive the subsidy back from the government, so in effect they pay the lower price PC. The difference in price between PP and PC is the per-vehicle amount of the subsidy (which is up to $3450 per car, as announced by the government). The number of electric vehicles traded increases to Q1 (because buyers want to buy more electric vehicles because of the lower effective price they have to pay, and sellers want to sell more electric vehicles because of the higher price they receive). One thing to notice is that the price doesn't go up by the whole amount of the subsidy - the difference between the original price P0 and the new higher price PP is less than the per-vehicle subsidy (PP - PC).

Who gains from the subsidy? It turns out that both buyers and sellers do. Without the subsidy, the consumer surplus (the difference between the amount that buyers are willing to pay, and what they actually pay) is the area FBP0. With the subsidy, the consumer surplus increases to the area FEPC. Consumers are better off with the subsidy. Without the subsidy, the producer surplus (the difference between the price that sellers receive, and their costs) is the area P0BH. With the subsidy, the producer surplus increases to the area PPGH. Sellers are better off with the subsidy.

However, not all groups gain from the subsidy. The government has to pay it, and that comes with an opportunity cost. Perhaps the government has less money to spend on schools, or roads, or raising the pay of striking nurses. Or perhaps they borrow, in which case future generations have to pay it back through higher taxes or decreased services. The area that represents the amount of subsidy paid by the government is PPGEPC (it is the rectangle that is the per-vehicle amount of the subsidy (PP - PC) multiplied by the number of subsidised vehicles Q1). [**]

Now, we can consider who gets the most benefit of the subsidy. In simple terms, on the diagram you can see that the price rise for sellers (from P0 to PP) is greater than the price fall for buyers (from P0 to PC). Sellers benefit more from the subsidy. In fact, the sellers' share of the subsidy is the area of the subsidy above the original price - the area PPGFP0. The buyers' share of the subsidy is the area of the subsidy below the original price - the area P0FEPC. The sellers' share is much larger than the buyers' share.

That need not necessarily be the case. Notice that the supply curve is quite steep, much steeper than the demand curve. The supply curve is relatively more inelastic than the demand curve. That means that sellers are less responsive to a change in price than buyers are. It turns out that whichever side of the market is more inelastic gets the larger share of welfare gains (or losses) when there are changes in market conditions. In the diagram above, the sellers are more price inelastic, and so they receive the greater share of the benefits of the subsidy. The reverse could be true. If buyers were more price inelastic, they would receive the greater share of the benefits of the subsidy. This is shown in the diagram below (which retains all of the same labels as the previous diagram, but shows the case where supply is more elastic than demand).

Coming back to the Newsroom article, if the price of electric vehicles is going up a lot, then that suggests that the supply is more inelastic than the demand. In fact, if the price actually went up by the entire amount of the subsidy, that would suggest that supply is perfectly inelastic, that is, completely unresponsive to price changes. Not everyone is suggesting that the price is going up by the full amount of the subsidy (from the same Newsroom article):

[Robert Young, director of New Zealand's biggest used car importer Nichibo Japan] estimated about half the $3450 subsidy would end up off-shore, benefiting the auction vendors in Japan and the UK as well as new car manufacturers. More would go to GST – meaning Kiwi EV buyers would pocket only about one-third of the subsidy.

It's hard to see what supply of electric vehicles to New Zealand would be very inelastic compared with demand. There are other markets that Japanese second-hand car sellers could be selling to, including Australia, Thailand, Malaysia, the Indian subcontinent, and southern Africa (all areas that drive on the left). Receiving a higher price for selling into the New Zealand market should induce Japanese sellers to shift to selling their EVs to New Zealand instead of into those other markets. It is also hard to see why demand for EVs in New Zealand would be very elastic compared with supply, but many substitutes (including petrol- or diesel-powered vehicles, which are due to be taxed and become more expensive concurrently with the introduction of the EV subsidy) and the high cost of EVs would play a part. It wouldn't surprise me to learn that the subsidy is roughly evenly shared between buyers and sellers.

Anyway, the key point of this post is that this is somewhat futile (again from the same Newsroom article):

But Transport Minister Michael Wood said the Government was keeping a close eye out for any attempts to take advantage of the subsidy.

“The new and imported used vehicle market is very competitive and I’m sure anyone attempting to distort market pricing will be called out," he said.

It's not the sellers that are distorting the market pricing, it's the subsidy.

[HT: Eric Crampton at Offsetting Behaviour]

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[*]  The subsidy could be paid to the sellers instead of the buyers. However, it turns out that the price and welfare effects would be exactly the same, regardless of who it is paid to. The only difference would be in terms of the transaction costs (the costs of administration of the subsidy). There is an argument that it would cost less to pay the subsidy to EV sellers, because there are fewer of them, and so fewer payments would need to be made. However, a canny government would realise that not every buyer would claim back the EV rebate, and so paying the subsidy to buyers in the form of a rebate may turn out to be cheaper overall. And even if it doesn't, it looks better politically for the government to pay the subsidy to 'ordinary car buyers' than to 'millionaire car salespeople'.

[**] For completeness, adding the consumer surplus and producer surplus together, and subtracting the subsidy, gives us a measure of total welfare (or total surplus). Without the subsidy, total welfare is the area FBH. With the subsidy, total welfare decreases to the area (FBH - BGE). The area BGE is the deadweight loss of the subsidy. However, this assumes that there are no positive externalities associated with electric vehicles, which there probably are - a person buying an EV is a person not buying a carbon-powered vehicle, and so each EV sold reduces carbon emissions (and reducing a negative externality is the equivalent of a positive externality).