Welfare Effects of a VIE/Import Subsidy: Large Country

Suppose there are only two trading countries, one importing and one exporting country. The supply and demand curves for the two countries are shown in the adjoining diagram. P_FT is the free trade equilibrium price. At that price, the excess demand by the importing country equals excess supply by the exporter.

The quantity of imports and exports is shown as the blue line segment on each country's graph. (That's the horizontal distance between the supply and demand curves at the free trade price) When a large importing country implements an import subsidy it will cause a decrease in the price of the good on the domestic market and an increase in the price in the rest of the world (RoW). Suppose after the subsidy the price in the importing country falls toand the price in the exporting country rises to . If the subsidy is a specific subsidy then the subsidy rate would be , equal to the length of the green line segment in the diagram.

The following Table provides a summary of the direction and magnitude of the welfare effects to producers, consumers and the governments in the importing and exporting countries. The aggregate national welfare effects and the world welfare effects are also shown. Positive welfare effects are shown in black, negative effects are shown in red, if you have a color print-out.

Import Subsidy Effects on:

Importing Country Consumers - Consumers of the product in the importing country experience an increase in well-being as a result of the import subsidy. The decrease in the price of both imported goods and the domestic substitutes increases the amount of consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.

Importing Country Producers - Producers in the importing country suffer a decrease in well-being as a result of the export subsidy. The decrease in the price of their product on the domestic market reduces producer surplus in the industry. The price decrease also induces a decrease in output of existing firms, a decrease in employment, and a decrease in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Importing Country Government - The government must pay the subsidy to encourage imports. These payments must come out of the general government budget. Who loses as a result of the subsidy payments depends on how the revenue is collected. If there is no change in total spending when the subsidy payments are made, then a reallocation of funds implies that some other government program is cut back. If the subsidy is paid for by raising tax revenues, then the individuals responsible for the higher taxes lose out. If the government borrows money to finance the subsidy payments, then the budget cut back or the tax increase can be postponed until some future date.

Regardless of how the subsidy is funded, though, someone in the domestic economy must ultimately pay for it. Refer to the Table and Figure to see how the magnitude of the subsidy payments are represented.

Importing Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers and producers. The net effect consists of three components: a negative terms of trade effect (B + C + D), a negative consumption distortion (H), and a negative production distortion (F). Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Since all three components are negative, the import subsidy must result in a reduction in national welfare for the importing country. However, it is important to note that a redistribution of income occurs, i.e., some groups gain while others lose.

Import Subsidy Effects on:

Exporting Country Consumers - Consumers of the product in the exporting country experience an decrease in well-being as a result of the import subsidy. The increase in their domestic price lowers the amount of consumer surplus in the market. Refer to the Table and Figure to see how the magnitude of the change in consumer surplus is represented.

Exporting Country Producers - Producers in the exporting country experience an increase in well-being as a result of the subsidy. The increase in the price of their product in their own market raises producer surplus in the industry. The price increase also induces an increase in output, an increase in employment, and an increase in profit and/or payments to fixed costs. Refer to the Table and Figure to see how the magnitude of the change in producer surplus is represented.

Exporting Country Government - There is no effect on the exporting country government revenue as a result of the importer's subsidy.

Exporting Country - The aggregate welfare effect for the country is found by summing the gains and losses to consumers, producers and the government. The net effect consists of three components: a positive terms of trade effect (b + c + d), a negative production distortion (d), and a negative consumption distortion (b). Refer to the Table and Figure to see how the magnitude of the change in national welfare is represented.

Although there are both positive and negative elements, the net national welfare effect reduces to area c which is positive. This means that an import subsidy implemented by a "large" importing country in a perfectly competitive market will raise national welfare in the exporting country.

However, it is also important to note that everyone's welfare does not rise when there is an increase in national welfare. Instead there is a redistribution of income. Producers of the product will benefit, but consumers will lose. A national welfare increase, then, means that the sum of the gains exceeds the sum of the losses across all individuals in the economy. Economists generally argue that, in this case, compensation from winners to losers can potentially alleviate the redistribution problem.

Click here to learn more about the compensation principle.

Import Subsidy Effects on:

World Welfare - The effect on world welfare is found by summing the national welfare effects in

the importing and exporting countries. By noting that the terms of trade gain to the exporter is equal to the terms of trade loss to the importer, the world welfare effect reduces to four components: the importer's negative production distortion (B), the importer's negative consumption distortion (D), the exporter's negative consumption distortion (f), and the exporter's negative production distortion (h). Since each of these is negative, the world welfare effect of the import subsidy is negative. The sum of the losses in the world exceeds the sum of the gains. In other words, we can say that an import subsidy results in a reduction in world production and consumption efficiency.

International Trade Theory and Policy - Chapter 90-31: Last Updated on 8/20/04