Export Subsidies in Agriculture

10
and High-Technology Industries

1. Describe the impact of each of the following goals from the Hong Kong WTO meet-
ing on (i) domestic prices and welfare of the country taking the action and (ii) world
prices and welfare for the partner countries.
a. Elimination of agriculture export subsidies.
Answer: Agriculture export subsidies in a small country have the effect of rais-
ing domestic prices. Export subsidies in a large country have the effect of rais-
ing domestic prices and lowering foreign prices. As such, any country abolish-
ing an export subsidy would decrease domestic prices. The associated decrease
in deadweight loss would increase domestic welfare (even more so in a large
country in which the abolition of the subsidy improves its terms of trade as well).
In the rest of the world, importers no longer derive a terms-of-trade benefit from
the export country’s subsidization program; therefore, they import at higher
prices and have lower welfare after subsidies are abolished. Foreign exporters, on
the other hand, enjoy a terms-of-trade and welfare gain.
b. Reduction of agricultural tariffs.
Answer: Agriculture tariffs in a small country also have the effect of raising do-
mestic prices. Tariffs in a large country have the effect of raising domestic prices
and lowering foreign prices. As such, any country abolishing an agricultural tar-
iff would decrease domestic prices. The associated decrease in deadweight loss
would increase domestic welfare in a small country, but welfare would decrease
in a large country due to worsening terms of trade. In the rest of the world, ex-
porters no longer suffer a terms-of-trade loss from the import country’s tariff
regime; therefore, they export at higher prices and have higher welfare after tar-
iffs are abolished. Foreign importers, on the other hand, suffer a terms-of-trade
and welfare loss.
c. Duty-free, quota-free access for 97% of goods originating in the world’s least de-
veloped countries.
Answer: As in part (b), removing tariffs and quotas decreases prices and dead-
weight losses in the import market. The exporting LDCs will benefit due to
higher export prices and will enjoy a gain in welfare as a result. Conversely, im-
porting LDCs will face higher world prices and have lower welfare. The welfare
calculation for other poor countries not included among the LDCs is more com-
plex because trade may be diverted to the LDCs from lower cost producers that
are still subject to trade barriers.

S-89
S-90 Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries

2. Consider a large country with export subsidies in place for agriculture. Suppose the
country changes its policy and decides to cut its subsidies in half.
a. Are there gains or losses to the large country, or is it ambiguous? What is the im-
pact on domestic prices for agriculture and on the world price?
Answer: There are unambiguous gains to the large exporting country. Not only
do deadweight losses decrease but terms-of-trade losses due to the subsidy are
also diminished.
b. Suppose a small food-importing country abroad responds to the lowered subsi-
dies by lowering its tariffs on agriculture by the same amount. Are there gains or
losses to the small country, or is it ambiguous? Explain.
Answer: From our discussion of small-country tariffs, the optimal tariff level is
zero. Hence, the small food importer gains from reducing its tariff as deadweight
losses decrease.
c. Suppose a large food-importing country abroad reciprocates by lowering its tar-
iffs on agricultural goods by the same amount. Are there gains or losses to this
large country, or is it ambiguous? Explain.
Answer: From our discussion of large-country tariffs, the optimal tariff level is
positive because (for small tariffs) terms-of-trade gains exceed deadweight losses.
If we assume that the (tariff-reducing) country was previously at its optimal tar-
iff, then welfare is reduced by cutting its tariff, but there is still an overall gain
from the bilateral reduction in subsidies and tariffs. Because terms-of-trade gains
for one party are terms-of-trade losses for the other, we can measure the net
overall benefits of bilateral trade barrier removal as the reduction in both coun-
tries’ deadweight losses.
3. Suppose Home is a small exporter of wheat. At the world price of $100 per ton,
Home growers export 20 tons. Now suppose the Home government decides to sup-
port its domestic producer with an export subsidy of $40 per ton. Use the following
figure to answer these questions.

Home
Price

D S

140

100

10 20 40 50 Quantity

a. What is the quantity exported under free trade and with the export subsidy?
Answer: Under the export subsidy, exports increase to 40 tons, whereas the
amount exported under free trade is 20 tons.
Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries S-91

b. Calculate the effect of the export subsidy on consumer surplus, producer surplus,
and government revenue.
Answer: Refer to the following figure:
Consumer surplus decreases by the area a ⫹ b:
⌬CS ⫽ ⫺(40 ⴢ 10) ⫺ 1⁄2(40 ⴢ 10)
⫽ ⫺600
Producer surplus increases by the area a ⫹ b ⫹ c:
⌬PS ⫽ (40 ⴢ 40) ⫹ 1⁄2(40 ⴢ 10)
⫽ 1,800
Government revenue decreases by the area b ⫹ c ⫹d:
⌬Gov. Rev. ⫽ ⫺(40 ⴢ 40)
⫽ ⫺1,600
Home
Price
b d
D S

140
a c
100

10 20 40 50 Quantity

c. Calculate the overall net effect of the export subsidy on Home welfare.
Answer: The net effect on Home welfare is the sum of changes in consumer
surplus, producer surplus, and government revenue: ⫺400. This is the total dead-
weight loss of the subsidy, equal to the area b ⫹ d.
S-92 Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries

4. Refer to problem 3. Rather than a small exporter of wheat, suppose that Home is a
large country. Continue to assume that the free-trade world price is $100 per ton
and that the Home government provides the domestic producer with an export sub-
sidy in the amount of $40 per ton. Because of the export subsidy, the local price in-
creases to $120 while the foreign market price declines to $80 per ton. Use the fol-
lowing figure to answer these questions.
Home
Price
D S

120
100

80

12 20 40 48 Quantity

a. Relative to the small-country case, why does the new domestic price increase by
less than the amount of the subsidy?
Answer: The new domestic price increases by less in the large-country case be-
cause part of the subsidy is offset by decreasing world prices. This reflects a
downward-sloping import demand curve in the rest of the world.
b. Calculate the effect of the export subsidy on consumer surplus, producer surplus,
and government revenue.
Answer: Refer to the following figure:
Consumer surplus decreases by the area a ⫹ b:
⌬CS ⫽ ⫺ (20 ⴢ 12) ⫺ 1⁄2(20 ⴢ 8)
⫽ ⫺320
Producer surplus increases by the area a ⫹ b ⫹c:
⌬PS ⫽ (20 ⴢ 40) ⫹ 1⁄2(20 ⴢ 8)
⫽ 880
Government revenue decreases by the area b ⫹ c ⫹ d ⫹ e:
⌬Gov. Rev. ⫽ ⫺(40 ⴢ 36)
⫽ ⫺1,440
Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries S-93

Home
Price

D b d S

120
a c
100
e
80

12 20 40 48 Quantity

c. Calculate the overall net effect of the export subsidy on Home welfare. Is the
large country better or worse off compared with the small country with the ex-
port subsidy? Explain.
Answer: The net decrease in welfare due to the subsidy is ⫺880. This is a larger
loss than in the small country because of Home’s terms-of-trade loss.
5. Refer to problem 3. Suppose Home is a small exporter of wheat. At the world price
of $100 per ton, Home growers export 20 tons. But rather than an export subsidy,
suppose the Home government provides its domestic producer with a production
subsidy of $40 per ton. Use the following figure to answer these questions.
Home
Price

D S

140

100

10 20 40 50 Quantity

a. What is the quantity exported with the production subsidy?

Answer: Under the production subsidy, Home’s quantity supplied increases from
40 to 50 tons. Because the Home consumer price (and hence quantity de-
manded) remains unchanged due to a production subsidy, the entire increase in
production is exported. The new quantity exported is 30 tons.
S-94 Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries

b. Calculate the effect of the production subsidy on consumer surplus, producer

surplus, and government revenue.
Answer: Refer to the following figure:
Consumer surplus is unaffected:
⌬CS ⫽0
Producer surplus increases by the area a ⫹ b ⫹ c:
⌬PS ⫽ (40 ⴢ 40) ⫹ 1⁄2(40 ⴢ 10)
⫽ 1,800
Government revenue decreases by the area a ⫹ b ⫹ c ⫹ d:
⌬Gov. Rev. ⫽ ⫺(40 ⴢ 50)
⫽ ⫺2,000
Home
Price
b
D d S

140
a c
100

10 20 40 50 Quantity

c. Calculate the overall net effect of the production subsidy on Home welfare. Is
the cost of the production subsidy more or less than the cost of the export sub-
sidy for the small country? Explain.
Answer: The net decrease in Home welfare is ⫺200. The welfare cost of a pro-
duction subsidy is less than the welfare cost of an export subsidy because there is
no deadweight loss associated with consumer behavior (i. e. , area b is not a dead-
weight loss as in the export subsidy case). The reason for this difference is that
under a production subsidy, the Home domestic price does not increase; firms
are paid the subsidy whether they export or not, so they do not charge the do-
mestic consumers more than Foreign consumers.
6. As mentioned in Headlines: Developing countries split over WTO farm pro-
tection, the failure of the WTO talks in Geneva in 2008 was in part due to dis-
agreement between developing countries over agricultural subsidies and tariffs. Ex-
plain how two developing countries, like Uruguay and China, can have such different
interests when it comes to agricultural subsidies and tariffs. Then explain how the in-
terests of a poor nation like Zambia differ from those of Uruguay and China.
Answer: As discussed in Headlines: Developing countries split over WTO
farm protection, China, which is an importer of many agricultural produces, is ru-
mored to designate rice, cotton, and sugar as special safeguard items. As an agricul-
tural exporter, Uruguay estimates that this designation, along with the special safe-
guard mechanism could result in 82% of China’s agricultural imports being eligible
Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries S-95

for higher duties. This move would harm developing countries that currently export
to China, such as Thailand and Uruguay. Zambia, on the other hand, is a developing
country in which 68% of people live below the poverty line, so Zambia is a major
beneficiary of agricultural subsidies by countries like the United States.
7. Explain why the WTO is more concerned with the use of direct-export subsidies
than production subsidies in achieving the same level of domestic support.
Answer: Direct-export subsidies create a consumption loss and a production loss,
whereas production subsidies generate only the latter.
8. Boeing and Airbus are the world’s only major producers of large, wide-bodied air-
crafts. But with the cost of fuel increasing and changing demand in the airline in-
dustry, the need for smaller regional jets has increased. Suppose that both firms must
decide whether they will produce a smaller plane. We will assume that Boeing has a
slight cost advantage over Airbus in both large and small planes, as shown in the fol-
lowing payoff matrix (in millions of U. S. dollars). Assume that each producer
chooses to either produce only large, only small, or no planes at all.

Airbus
Large Planes Small Planes Not Produce
Planes
Large

-5 125 0
10 115 115
Boeing

Planes

100 0 0
Small

150 15 150
Not Produce

100 125 0
0 0 0

a. What is the Nash equilibrium of this game?

Answer: Recall that the idea of Nash equilibrium is that each firm must make its
own best decision, taking as a given each possible outcome from the other firm.
In this case, if Boeing produces large planes, Airbus’ optimal reaction is to choose
to produce small planes: Its payoff is 125 million (vs. 0 million and ⫺5 million for
the other alternatives). Similarly, if Airbus produces small planes, Boeing’s optimal
reaction is to produce large planes: Its payoff is 115 million. In this case, consider-
ing both firms’ optimal reaction to each choice of its rival yields two Nash equi-
libria: where one firm produces large planes and the other firm produces small
planes.
b. Are there multiple equilibria? If so, explain why. Hint: Guess at an equilibrium
and then check whether either firm would want to change its action, given the
action of the other firm. Remember that Boeing can change only its own ac-
tion, which means moving up or down a column, and likewise, Airbus can
change only its own action, which means moving back or forth on a row.
Answer: Starting from either of the equilibria illustrated in the payoff matrix be-
low, it is possible to verify that no action on the part of any player can improve
its payoff. It also makes intuitive sense why these two equilibria are the best pos-
sible outcomes for the firms because they make both firms a monopolist in dif-
ferent aircraft markets.
S-96 Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries

Airbus
Large Planes Small Planes Not Produce

Planes
-5 125 0

Large
10 115 115

Boeing
100 0 0

Planes
Small
150 15 150

Not Produce
100 125 0

0 0 0

9. Refer to problem 8. Now suppose the European government wants Airbus to be the
sole producer in the lucrative small-aircraft market. Then answer the following:
a. What is the minimum amount of subsidy that Airbus must receive when it pro-
duces small aircraft to ensure that outcome as the unique Nash equilibrium?
Answer: Assume that the firms start out in the Nash equilibrium wherein Boe-
ing produces small planes and Airbus produces large planes. To get Airbus to
change production to small planes, the European Union needs the small-plane
payoff to exceed large-plane payoff; that is, small-plane payoff must increase by at
least 101 million. Given a subsidy of 101 million, Airbus switches production to
small planes; then, Boeing switches production to large planes because it is no
longer Boeing’s optimal response to produce small planes at the same time as Air-
bus. The new unique Nash equilibrium (with subsidy) is for Airbus to produce
small planes and Boeing to produce large planes.
b. Is it worthwhile for the European government to undertake this subsidy?
Answer: When judging whether a policy is worth it, we consider its implication
for welfare (i. e. , its effect on the sum of producer surplus, consumer surplus, and
government revenue). In this case, changing from the production of large planes
to the production of small planes increases Airbus producer surplus by 25 as profits
increase from 100 to 125. Producers also collect 101 from the government in the
form of a subsidy. Government expenditure increases (revenue decreases) by 101
to finance the subsidy. Adding up, overall welfare increases by 25. It is worth it.
10. Here we examine the effects of domestic sales taxes on the market for exports as an
example of the “targeting principle. ” For example, in the domestic market, there are
heavy taxes on the purchase of cigarettes. Meanwhile, the United States has several
very large cigarette companies that export their products abroad.
a. What is the effect of the sales tax on the quantity of cigarette exports from the
United States? Hint: Your answer should parallel the case of production subsidies
but for a consumption tax instead.
Answer: Refer to the following figure: Putting a tax on consumers is analogous
to providing a subsidy to domestic production. Just as the subsidy boosted the
amount of domestic production, leaving quantity demanded unchanged, so does
a consumption tax reduce domestic quantity demanded while leaving domestic
production unchanged. The resulting level of exports is higher than it was be-
fore the consumption tax.
 Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries S-97

Price Price

X
X⬘
D S
C
P*+ t
B
P* M*
C⬘

D⬘

D2 D1 S1 Quantity X1 X2 Exports

(a) Domestic Market (b) Export Market

b. How does the change in exports, if any, due to the sales tax compare with the ef-
fect of an export subsidy on cigarettes?
Answer: Exports under the consumption tax are higher than under free trade,
although not as high as they would be under an export-subsidy regime. Under
an export-subsidy regime, exports increase due to a drop in quantity demanded
and an increase in domestic production.
11. Refer to problem 10. Based on your answer there, would foreign countries have a
reason to object to the use of a sales tax on cigarettes by the United States? Based on
your knowledge of the GATT/WTO provisions (see Side Bar: Key Provisions of
the GATT, in Chapter 8), are foreign countries entitled to object to the use of such
a tax?
Answer: A consumption tax, like a production subsidy, increases the quantity ex-
ported, but not by as much as an export subsidy. In this sense, foreign countries have
equal basis to object to either production subsidies or consumer taxes as less damaging
types of export subsidies. However, because they do not cause as big a change in ex-
port volume, in many cases (such as the negotiations at the Hong Kong WTO meet-
ings) production subsidies are not dealt with as strongly or urgently as export subsi-
dies. In Article XVI of the GATT, a subsidy is defined as: “. . . any form of income
or price support, which operates directly or indirectly to increase exports of any prod-
uct from, or to reduce imports of any product into, its territory. ” A consumption tax
as outlined above would fit into this broad definition, and WTO member countries
would be entitled to request that these subsidies be limited.
12. To improve national welfare, a large country would do better to implement an ex-
port subsidy rather than an import tariff. Is this true or false? Explain why.
Answer: A large country may improve its terms of trade with an import tariff, lead-
ing to an overall gain in national welfare. With an export subsidy, the additional
amount exported drives down the world price so that the large country is worse off.
Namely, the country’s welfare is hurt by an export subsidy due to the loss in terms of
trade. Thus, the statement is false.
13. Who gains and who loses when governments in Europe and the United States pro-
vide subsidies to Airbus and Boeing?
Answer: The clear winners are foreign consumers of Boeing and Airbus because the
subsidies lower the price they pay. The governments in Europe and the United States
S-98 Solutions ■ Chapter 10 Export Subsidies in Agriculture and High-Technology Industries

incur the cost of the subsidy. The aircraft manufacturers gain from lowering the cost
of production with the subsidy. The net effect on the European and American wel-
fare depends on whether the government assistance successfully affects competition
such that the profit earned by the aircraft manufacturers exceeds the cost of the sub-
sidy to the government.
14. Provide motivations for the use of export subsidies. Does your answer depend on
whether firms compete under perfect or imperfect competition?
Answer: Export subsidies are used to encourage the domestic firm to produce more
in a particular industry. Moreover, subsidies may be offered if there is a potential for
the positive externality from the production of the product to spill over to the rest of
the economy. Under imperfect competition, a government can use subsidies to
strategically affect the interaction between firms and increase the profits of its own
domestic firm.