The question is about whether a per unit tax or subsidy to one side of a market is fully offset by a change in the price charged to the other side.
Under complete ‘pass through,’ subsidies are fully offset by price reductions and thus subsidies become completely inconsequential. Complete pass through could easily arise in a model, but is much less likely in real life.
Under incomplete ‘pass through,’ the side receiving the subsidy captures some value. The subsidy then encourages entry into the subsidized activity.
You will fail to get complete pass through if any of the following conditions hold:
- There are ‘transaction costs’ that impede adjustment of prices.
- Participants on at least one side of the market pay a fixed cost as well as a cost per unit.
- The side receiving a subsidy is not perfectly competitive.
I would say that (1), (2), and (3) are all important reasons for incomplete pass through on exchanges.
(1) Many exchanges have minimum tick sizes. This limits makers ability to undercut one another. Once you have a minimum tick size, transaction costs make complete pass through impossible.
(2) Some orders originate from brokers. There is fixed fee component to retail brokerage fees.
(3) The business of market making is highly competitive as a whole. However, market making in at a specific asset/time/place can be much less so. For example, you would likely see greater pass through for highly liquid tokens where many market makers are active simultaneously. For a highly illiquid token, however, there may be only one or two market makers active at a time. In this case, more of the subsidy would be retained by the market makers, the narrowing of the bid ask spread via passthrough is smaller, the increase in the depth of liquidity available as a result of the subsidy is larger.
(Note: (3) implies that the subsidy primarily encourages entry into illiquid trading pairs. Interestingly, after entry, the incumbent market maker will capture less of the subsidy and there will be more pass through. Their is potentially a phenomenon where subsidies work to bootstrap new markets, but you move towards full pass through as the market matures. This is a nice feature because you usually want to selectively subsidize entrepreneurial activity. You do not want the subsidy to be captured by a market that could function effectively without it.)
The concluding section of the following paper has a really awesome and math free discussion of pass through: