International Trade Theory and Policy
by Steven M. Suranovic

Trade 90-1A

Production Subsidies as a Source of Trade

This section will show how a production subsidy can cause trade for a small perfectly competitive open economy. The analysis indicates that domestic policies can be a source of trade even in the absence of other reasons for trade. (Click here to see a list of other major reasons for trade) In other words, even if countries were identical with respect to their resource endowments, their technology and their preferences and even if there were no economies of scale or imperfectly competitive markets, domestic policies could induce trade between countries.

Consider a small open economy with a perfectly competitive industry. Let the domestic market be represented by the supply and demand curves in the adjoining diagram. Suppose initially that free trade is allowed with the rest of the world, but, by coincidence, (actually by assumption) let the free trade price be exactly equal to the autarky price for the good. This is shown as prices, PFT. This implies that no imports or exports occur even though there is free trade.

Next suppose that the government of this country offers a specific (per unit) production subsidy to the domestic firms. Let the subsidy rate be set at "s". This means the government will pay "s" dollars for every unit the domestic firm produces, regardless of where the product is sold.

The subsidy effectively raises the price that the producer receives for each unit of the good produced and sold. At the same time, the subsidy will not have an effect upon the domestic price that consumers pay. In other words, the subsidy will cause the price received by producers (we'll call this the producer price) to rise above the price paid by consumers (called the consumer's price). The new producer price is labeled PP in the diagram, while the consumer price, PC, remains equal to the free trade price. These price changes occur because these prices will allow domestic firms in the small country to maximize their profit in the face of free competition with firms in the rest of the world.

The subsidy will increase domestic production. At the market price PFT, domestic firms were willing to supply to Q1. Once the producer price rises to PP, domestic supply will rise to Q2. Demand would remain the same, however, since the consumer price remains fixed. The difference between domestic supply and demand, Q2 - Q1, represents the level of exports the country makes to the rest of the world. Since exports did not exist prior to the subsidy, this is an example in which a domestic policy (a production subsidy) can cause trade to occur (exports).

International Trade Theory and Policy - Chapter 90-1A: Last Updated on 10/17/02