IB Economics 4.2.3 Subsidy/export Subsidy Notes

Subsidies: Protecting Producers Without Taxing Imports

1. A subsidy is a payment from the government to producers, and in trade policy it protects domestic firms without taxing or banning imports outright.

1. There are two types, in different markets: a production subsidy is paid to domestic firms that compete with imports, while an export subsidy is paid on each unit a firm sells abroad.
2. Both are payments to producers, but only the export subsidy raises the price consumers pay at home.

How a Production Subsidy Works

1. Start in free trade in an import market, where the world price $P_w$ sits below the domestic no-trade price, so at $P_w$ domestic firms supply $Q_{s1}$, consumers demand $Q_{d1}$, and imports fill $Q_{d1} - Q_{s1}$.
2. The government pays domestic producers a subsidy $s$ per unit, which shifts the domestic supply curve right from $S_{D1}$ to $S_{D1} + \text{subsidy}$, so producers receive $P_w + s$ per unit while consumers still pay the world price $P_w$.
3. Domestic supply rises from $Q_{s1}$ to $Q_{s2}$, demand stays at $Q_{d1}$, and imports shrink to the smaller $Q_{d1} - Q_{s2}$.

1. The lettered areas capture the effect on each group.
   1. Government spending on the subsidy: $c + d$, the subsidy $s$ times the subsidised output $Q_{s2}$.
   2. Gain in producer surplus: $c$.
   3. Deadweight welfare loss: $d$, the production inefficiency from higher-cost domestic output.
   4. Consumer surplus: unchanged, because consumers keep paying $P_w$.

Production Subsidy: Winners, the Neutral Consumer, and the Welfare Cost

1. A production subsidy sorts stakeholders into clear winners, an untouched consumer, and those who bear the cost.
2. Domestic producers win: they supply more ($Q_{s2}$ instead of $Q_{s1}$) at the higher received price $P_w + s$, so producer surplus grows by $c$ and the extra output supports jobs.
3. Consumers are neutral: they still pay $P_w$ and buy $Q_{d1}$, so consumer surplus does not change; they simply switch some purchases from imports to domestic goods at the same price.
4. The government bears the cost: it pays the subsidy $s \times Q_{s2}$, money that carries an opportunity cost.
5. Foreign producers lose: imports fall from $Q_{d1} - Q_{s1}$ to the smaller $Q_{d1} - Q_{s2}$.
6. Society bears a welfare loss: the extra output from $Q_{s1}$ to $Q_{s2}$ is made by less efficient domestic firms at $P_w + s$ rather than bought at the world price $P_w$, so area $d$ is a deadweight loss.
7. Because consumers are untouched, this welfare loss is smaller than under a tariff or quota, but the subsidy is also less effective at cutting imports.

How an Export Subsidy Works

1. An export subsidy works in an export market, where the country is efficient enough that the world price $P_w$ sits above its no-trade price, so in free trade consumers demand $Q_{d1}$, domestic firms supply $Q_{s1}$, and the excess supply $Q_{s1} - Q_{d1}$ is exported.
2. The government pays $s$ per unit to encourage exports, shifting supply right from $S_{D1}$ to $S_{D1} + \text{subsidy}$, so producers receive $P_w + s$.
3. The domestic price also rises to $P_w + s$, because firms will only sell at home for what they can earn abroad with the subsidy, so demand falls from $Q_{d1}$ to $Q_{d2}$, supply rises from $Q_{s1}$ to $Q_{s2}$, and exports grow to the larger $Q_{s2} - Q_{d2}$.

1. Because the home price rises to $P_w + s$, consumers lose surplus, producers gain, the government pays $s$ times the exports, and the deadweight loss is the two shaded triangles on the diagram.

Export Subsidy: Winners, Losers, and the Welfare Cost

1. An export subsidy produces bigger winners but also creates losers on the consumer side.
2. Domestic producers win the most: they supply more ($Q_{s2}$ instead of $Q_{s1}$) at the higher price $P_w + s$, so producer surplus rises and the extra output supports jobs.
3. Consumers lose: they pay the higher price $P_w + s$ and buy less ($Q_{d1}$ falls to $Q_{d2}$), so consumer surplus falls, and because the price rise takes a larger share of income from poorer households the policy is regressive.
4. The government bears the cost: it pays the subsidy on every unit exported, equal to $s$ times the exports $Q_{s2} - Q_{d2}$.
5. Foreign producers lose: they surrender market share to the subsidised exports.
6. Society bears a larger welfare loss: the loss is two triangles, one from the fall in domestic demand and one from the rise in domestic supply, larger than a production subsidy's because consumers are harmed on top of the production inefficiency.

Production or Export Subsidy: Comparing the Two

1. Both subsidies raise producer surplus, lift domestic output, and protect jobs, and both cost the government money and waste resources through inefficient production.
2. The decisive difference is what happens to consumers: a production subsidy leaves them paying $P_w$, so they are neutral and the only welfare loss is the production triangle, while an export subsidy raises the price they pay to $P_w + s$, so they lose surplus and the welfare loss is two triangles.