International Trade Theory and Policy
by Steven M. Suranovic

Trade 90-30

Price Effects of a Voluntary Import Expansion (VIE) / Import Subsidy: Large Country

Suppose Mexico, the importing country in free trade, is encouraged to implement a voluntary import expansion on imports of wheat. A VIE is designed to expand the flow of wheat across the border.

If the flow of wheat could be expanded by decree, then the supply of wheat to the Mexican market would rise causing a decrease in the price of wheat. The price of all wheat sold in Mexico, both Mexican wheat and US imports would fall in price. The lower price would raise Mexico's import demand.

Since Mexico is assumed to be a "large" country, the higher wheat supply to Mexico would reduce supply in the US market and induce an increase in the US price. The higher price would raise US export supply.

However, a quantitative expansion is unlikely to be workable. A decree to expand imports would force Mexican importers to buy the products in the US market at a higher price and resell them in Mexico at a lower price. Each unit imported would cause a loss equal to the difference in prices. An alternative method to expand imports is for the government to implement an import subsidy. An import subsidy would expand imports because the loss to importers would be covered by the government. Thus a government who agrees to voluntarily expand imports could do so by implementing an import subsidy.

An import subsidy equilibrium will be reached when the following two conditions are satisfied.

where S is the specific import subsidy, is the price in Mexico after the subsidy, andis the price in the US after the subsidy. The first condition represents a price wedge between the final US price and the Mexican price, equal to the amount of the import subsidy. The prices must differ by the subsidy because US suppliers of wheat must receive the same price for their product, regardless of whether the product is sold in the US or Mexico and all wheat sold in Mexico must be sold at the same price. Since a subsidy is paid to Mexican importers, the only way for these price equalities within countries to arise is if the price differs across countries by the amount of the subsidy.

The second condition states that the amount the US wants to export at its new higher price must be equal to the amount Mexico wants to import at its new lower price. This condition guarantees that world supply of wheat equals world demand for wheat.

The import subsidy equilibrium is depicted graphically on the adjoining graph. The Mexican price of wheat falls from PFT to which raises its import demand from QFT to QS. The US price of wheat rises from PFT to which raises its export supply, also from QFT to QS. The difference in the prices between the two markets is equal to the export subsidy rate S.

International Trade Theory and Policy - Chapter 90-30: Last Updated on 2/25/97