Price Effects of an Export Subsidy: Large Country Case

Suppose the US, the exporting country in free trade, implements a specific export subsidy on exports of wheat. A subsidy to exports will encourage the flow of wheat across the border. It will now cost less to move the product from the US into Mexico.

As a result the supply of wheat to the Mexican market will rise causing a decrease in the price of wheat. Since the US is assumed to be a "large" country, the price of all wheat sold in Mexico, both Mexican wheat and US imports will fall in price. The lower price will raise Mexico's import demand.

The higher wheat supply to Mexico will reduce supply in the US market and induce an increase in the US price. The higher price will raise US export supply.

A new subsidy-ridden equilibrium will be reached when the following two conditions are satisfied.

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

International Trade Theory and Policy - Chapter 90-26: Last Updated on 2/25/97