Domestic Production Subsidies
by Steven Suranovic ©1997-2004
A domestic production subsidy is a payment made by a government to firms in a particular
industry based on the output or production. The subsidy can be specified either as an ad valorem
subsidy (% of the value of production) or as a specific subsidy (dollar payment per unit of
output). The domestic production subsidy is different from an export subsidy. The production
subsidy provides a payment based on all production regardless of where it is sold. The export
subsidy, on the other hand, only offers a payment to the quantity or value that is actually
Domestic production subsidies are generally used for two main reasons. First, subsidies provide a way of raising the incomes of producers in a particular industry. This is in part why many countries apply production subsidies on agricultural commodities; because it raises the incomes of farmers. The second reason to use production subsidies is to stimulate output of a particular good. This may be done because the product is assumed to be critical for national security. This argument is sometimes used to justify subsidies to agricultural goods, as well as steel, motor vehicles, and many other commodities. Countries might also wish to subsidize certain industries if it is believed that the industries are important in stimulating growth of the economy. This is the reason many companies receive research and development subsidies. Although R&D subsidies are not strictly production subsidies, they can have similar effects.
We will analyze the international trade effects of a domestic production subsidy using a partial equilibrium analysis. We will assume that the market in question is perfectly competitive and that the country is "small". We will also ignore any benefits the policy may generate such as creating a more pleasing distribution of income or generating valuable external effects. Instead we will focus entirely on the producer, consumer and government revenue effects of each policy.
Next we consider the effects of a production subsidy under two different initial conditions. In the first case the subsidy is implemented in a country that is not trading with the rest of the world. This case is used to show how a domestic policy can cause international trade. The second case considers the price and welfare effects of a production subsidy implemented by a country that is intitially importing the good from the rest of the world.
International Trade Theory and Policy
Lecture Notes: ©1997-2004 Steven M. Suranovic