GLOBE

Countervailing Duties in a Perfectly Competitive Market

by Steven Suranovic ©1997-2004

Trade 110-3 

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The WTO allows countries to place a countervailing duty (CVD) on imports when a foreign government subsidizes exports of the product which in turn causes injury to the import competing firms. The countervailing duty is a tariff designed to "counter" the effects of the foreign export subsidy. The purpose of this section is to explain the effects of a countervailing duty in a perfectly competitive market setting. See Section 20-4 for a more complete description of the CVD law.

We will assume that there are two large countries trading a particular product in a partial equilibrium model. The exporting country initially sets a specific export subsidy. That action is countered with a CVD implemented by the importing country. Below we will first describe the effects of the export subsidy (which will closely mimic the analysis in section 90-26) after which we will consider the effects of the CVD action in response.

The Initial Export Subsidy

An export subsidy will reduce the price of the good in the import market and raise the price of the good in the export market relative to the free trade price. After the subsidy is imposed the following two conditions will describe the new equilibrium.

where S is the specific export subsidy, is the price that prevails in the import market after the subsidy, andis the price that prevails in the export market after the subsidy. The first condition means that prices in the two countries must differ by the amount of the subsidy. The second condition means that export supply, at the price that now prevails in the export market, must equal import demand, at the price that prevails in the import market.

The effects of the subsidy are depicted in the adjoining diagram. The initial free trade price is labeled PFT. In free trade the exporting country exports (Sex0 - Dex0) and the importing country imports (Dim0 - Sim0). Since there are the only two countries in the model, free trade exports are equal to imports and are shown as the blue line segments in the diagram. When the subsidy is imposed, the price in the export market rises to PexS, while the price in the import market falls to PimS. The higher level of exports with the subsidy, given by (Sex1 - Dex1), are equal to imports, given by (Dim1 - Sim1) and are depicted by the red line segments 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 as a result of the subsidy. 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.

Welfare Effects of the Initial Export Subsidy

Importing Country Exporting Country
Consumer Surplus + (G + H + I + J + K) - (a + b)
Producer Surplus - (G + H) + (a + b + c + d + e)
Govt. Revenue 0 - (b + c + d + e + f + h + i + j + k + l)
National Welfare + I + J + K - (b + f + h + i + j + k + l)
World Welfare - (I + K) - (b + f)

The Table shows that in the case of a large exporting country, the export producers benefit from the subsidy while the consumers of the product in the exporting country lose. Because of the cost of the subsidy by the exporting country government, which must ultimately be paid for by the taxpayers, the net national welfare effect for the exporting country is negative.

The importing country also experiences an income redistribution. The consumers in the importing country benefit from the foreign subsidy while import competing producers suffer losses. The net effect for the importing country is positive since the gains to consumers outweigh the losses to producers.

The world welfare effects of the export subsidy are also negative.

The Countervailing Duty

Despite the fact that the export subsidy generates net benefits for the importing country, the importing country is allowed under WTO rules to protect itself from these benefits!? A CVD may be placed if it can be shown that a subsidy is indeed in place, (we will assume it is here) and if the subsidy causes injury to the import competing firms.

It is worth emphasizing that the CVD law, in this case, does not protect the "country", nor does it protect consumers. The law is designed to aid import firms exclusively. No evaluation of the effects on consumers and no evaluation of the national welfare effects is required by the law. The only requirement is that injury be caused to the import competing firms.

In this simple example of a large country implementing an export subsidy, injury would indeed be apparent. The export subsidy lowers the price of the good in the import market in this model and causes an increase in imports from abroad. Supply by the import-competing firms would fall (from Sim0 to Sim1 in the diagram). Producer surplus, indicating a reduction in industry profits, would also fall. Since less output would be produced by the import-competing industry, the industry would need fewer factors of production. This would likely mean a reduction in the number of workers employed in the industry. In the adjustment process, firms in the industry may lay-off workers and close factories. All of these effects are valid criteria used to judge injury in CVD cases.

So let's consider the effects of a countervailing duty in response to the export subsidy described above. A CVD is simply an tariff set on imports to counter the effects of the foreign export subsidy. CVD laws require that the size of the CVD be just enough to offset the effects of the export subsidy. In the US, the US International Trade Administration determines the size of the foreign subsidy. If a CVD action is taken, the CVD is set equal to the foreign subsidy.

So, imagine that the importing country now sets a specific CVD (t) equal to the original export subsidy (S). As with any tariff set by a large importing country, the tariff will cause the price in the importing country to rise and the price in the exporting country to fall. What's different from the standard tariff analysis, is that the prices in this case are not now equal to each other. Instead the price in the import market begins lower by the amount of the export subsidy, S, than the price in the export market. The CVD, then, will drive the prices in the two markets back together.

The final equilibrium must satisfy the following two conditions.

However, since t = S, the first condition reduces to . This means that in the final equilibrium the prices must be equal in both countries and export supply must be equal to import demand. These conditions are satisfied only at the free trade price.

Thus, the effect of the CVD is to force the prices in the two markets back to the free trade prices.

As a result imports will fall in the importing country (back to Dim0 - Sim0 in the diagram), domestic supply will rise (from Sim1 to Sim0), employment in the import-competing industry will rise back up and producer surplus in the industry will also rise. Thus, the CVD will be effective in eliminating the injury caused to import competing firms.

Welfare Effects of the CVD

But, let's also take a look at the overall welfare effects of the CVD, assuming, as is often the case, that the CVD and the export subsidy remain in place. There are two ways to consider the effects of the CVD. We can look at the effects relative to the case when just the export subsidy was in place. Or, we can look at the effects relative to when there was no export subsidy and no CVD. We'll do it both ways.

First, let's consider the welfare effects of the CVD relative to the situation when the export subsidy alone was in place. These effects are summarized in the Table below.

Welfare Effects of a CVD

Importing Country Exporting Country
Consumer Surplus - (G + H + I + J + K) + (a + b)
Producer Surplus + (G + H) - (a + b + c + d + e)
Govt. Revenue + (C + D + E + J) + (b + c + e + f + h + l)
National Welfare + (C + D + E) - (I + K) + (b + f + h + l) - (d)
World Welfare + (b + f + h + l) - (I + K) =

b + f + I + K

Note that the effects on consumers and producers in both countries are equal and opposite to the effects of the export subsidy. Thus, producers in the import-competing industry gain in surplus from the CVD exactly what they had lost as a result of the foreign export subsidy. Consumers in the import industry lose from the CVD, producers in the exporting country lose while consumers in the exporting country gain.

The importing government now collects tariff revenue from the CVD which benefits someone in the importing country. The exporting government, however, experiences a reduction in its subsidy expenditures. This occurs because the CVD reduces trade and thus reduces the number of units exported. As a result the government (i.e., the taxpayers) in the exporting country benefit from the CVD.

The national welfare effects in both countries are ambiguous in general. In the importing country, a terms of trade gain may outweigh two deadweight losses and cause national welfare to rise even further. Interestingly, the export subsidy and the CVD may each raise welfare for the importing country. In the export country, the net national welfare effect may be positive or negative.

The world welfare effects are found by summing the national welfare effects in both countries. The expression is simplified first by noting that area (C + D + E) = area (d) and second by noting that area (h) = twice area I or (2I) and area (l) = area (2K). The final expression shows that world welfare will rise as a result of the CVD.

Welfare Effects of the Combined Policies (Export Subsidy + CVD)

Next let's consider the welfare effects of the export subsidy and the CVD combined. In this case we compare the welfare status of each country after both policies are in place relative to the situation when neither policy is imposed. The effects can be calculated by either by summing the individual welfare effects from each of the two stages depicted above, or, by noting that prices have not changed from the initial pre-subsidy state to the final post-CVD state, but that the governments do have expenditures and receipts respectively.

The welfare effects are summarized in the Table below.

Welfare Effects of an Export Subsidy plus a CVD

Importing Country Exporting Country
Consumer Surplus 0 0
Producer Surplus 0 0
Govt. Revenue + (C + D + E + J) - (d + i + j + k)
National Welfare + (C + D + E + J) - (d + i + j + k)
World Welfare 0

Since the prices in each country after the CVD are the same as prices before the export subsidy, there is ultimately no change in producer or consumer surplus in either country. Everyone participating in the market is left as well-off as they were at the start.

However, since the exporting country maintains the export subsidy and the import country maintains the CVD there are government revenue effects. In the exporting country, the government continues to make expenditures for the export subsidy. This represents a cost to the taxpayers of the country which does not even generate the intended benefit for the export industry. In the importing country, the government collects tariff revenue as a result of the CVD. This generates benefits to the recipients of the resulting additional government spending.

The net national welfare effect in each country is the same as the government effects. This means that the importing country benefits from the export subsidy plus CVD while the exporting country loses from the combined policies.

The world welfare effects of the combined policies is neutral.

This means that the exporting country loses exactly the same amount as the importing country gains. The ultimate effect of the export subsidy plus CVD is that the exporting country government transfers money to the importing country government with consumers and producers left unaffected. In practice what happens is that exporting country producers receive an export subsidy payment from their government when their product leaves the port, bound for the importing country. When the product arrives, the importing country government collects a tariff (or CVD) exactly equal to the subsidy payment. Thus, the export firms turn over the extra monies they had just received from their own government to the government of the importing country.

These effects described here hold only for markets that are perfectly competitive. If the markets are oligolpolistic, or contain market imperfections or other distortions, then the effects of the export subsidy and CVD may differ.


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©1998-2004 Steven M. Suranovic, ALL RIGHTS RESERVED
Last Updated on 7/23/98