Production Subsidy Effects in a Small Importing Country

In many instances domestic policies affect an industry that is either an exporter or an import-competitor initially. In this example we consider the price, production and welfare effects of a production subsidy when the subsidized product is initially imported into the country.

We depict this equilibrium in the adjoining diagram. The free trade price is given by P_FT. The domestic supply is S₁ and domestic demand is D₁ which determines imports in free trade as D₁ - S₁ (the red line).

When a production subsidy "s" is imposed, the domestic producer price rises by the subsidy value to to P_P. Because free trade is maintained and the importing country is small, the domestic consumer price remains at P_FT. Thus the effect of the subsidy in this case is to raise domestic supply from S₁ to S₂ while domestic demand remains at D₁. As a result, imports fall from (D₁ - S₁) to (D₁ - S₂).

The welfare effects of the production subsidy are shown in the Table below. The letters refer to the area in the previous graph. Red letters indicate losses while black letters indicate gains.

Consumers are left unaffected by the subsidy since the domestic consumer price remains the same. Producers gain in terms of producer surplus. The subsidy causes the price producers receive to rise to P_P , which in turn stimulates an increase in output from S₁ to S₂. The government, however, must pay the subsidy and that means someone must pay higher taxes to fund the subsidy. The total amount of the subsidy payments is given by (P_P - P_FT) in the diagram (which corresponds to the subsidy rate), times the quantity produced, S₂. Since the cost of the subsidy exceeds the benefits to producers, the net national welfare effect of the production subsidy is negative. Although some segments of the population benefit, there remains a production efficiency loss, given by area b.

In the rest of the world, the small country assumption implies that this domestic policy (the production subsidy) would have no noticeable effects. Foreign prices would remain unchanged and although their exports to this country would fall, these changes in trade volumes would have no noticeable impact in the rest of the world. Thus, the welfare effects are so insignificant in the rest of the world they are assumed to be zero.

International Trade Theory and Policy - Chapter 95-1B: Last Updated on 10/17/03