Tutorial on Partial Equilibrium Modeling: Export Subsidy by a Large Country Exporter The Microeconomics of International Trade ECN 230 Roberto J. Garcia School of Economics and Business, UMB

2 Economic effects of an export subsidy Export subsidy: case of a specific subsidy A per unit subsidy on exports (e.g., s 0 = 30kr/kg) such that the difference between the domestic price and the world price is equal to s 0, i.e., (P D ) 1 - (P W ) 1 = s 0. An export subsidy has implications for prices, which affects economic behavior and welfare. The economic effects are studied by analyzing the change in prices on: Production, consumption and trade patterns, and Producer and consumer welfare and government's budgetary position (i.e., expenditures and revenue).

3 Economic effects of an export subsidy Market analysis Analyzing the production, consumption and trade effects: the perspective of the exporting country [Q D ] 1 [Q S ] 1    [Q X ] 1 [P W ] 1 Exporter's domestic market World market

4 Economic effects of an export subsidy Economic intuition and expectations Regardless of the reason an export subsidy is applied, the result is an increase in the quantity exported (ES shifts to the right by the value of the per unit subsidy). The world price decreases (  P W ) because a large seller on the international market increases supply, i.e., a TOT effect. The internal price in the exporter's market increases (  P D ) because more needs to be produced and there is greater scarcity of the good in the domestic market because more is exported. Producers and consumers react to the change in the domestic price, from P W to [P D ] 1. Producers respond to price increases by increasing output (  Q S ) and the subsidy tied to export performance means  Q X. In partial equilibrium analysis, a price increase is expected to result in a decrease in consumption,  Q D, allowing  Q X. Government expenditures (budgetary outlays) are equal to the subsidy, s 0, times the export volume, [Q S - Q D ] 1.

5 Economic effects of an export subsidy Welfare analysis Analyzing economic costs and income transfers among producers, consumers, traders and the government: the exporting country's perspective Exporter's market Welfare analysis Δ CS Δ PS Δ G Δ NSW - (a) + (a+b+c) - (b+d) - (e+f+g+h+i) - (2b+c+d) - (e+f+g+h+i) S0↓S0↓

6 Economic effects of an export subsidy Economic interpretation of welfare areas Area 'a' represents the value lost by consumers that is gained by producers, i.e., a tax on consumers; it is an income transfer from the consumer to the producer. Area 'b' represents a part of the total value lost by the economy, a "dead-weight loss" (DWL) in consumption. The DWL in consumption is the cost to society of consuming less of the good as a result of distorted prices. The decreased expenditures reflects a misallocation of resources (i.e., a sub-optimal consumption mix). Area 'c' represents part of the value gained by producers that is a subsidy by the government; in it part of the income transfer from the government to producers.

7 Economic effects of an export subsidy Area 'd' represents an economic cost to society, a "dead-weight loss" (DWL) in production. The DWL in production is the cost to society of producing more of the exported good beyond what is commercially viable. The increased production reflects a misallocation of resources as a result of the distorted prices. Area 'e+f+g+h+i' represents the part of the budgetary outlay associated with the negative TOT effect. It is an income transfer by the export-country's government to subsidize consumers in the importing country. The value represents the cost of a policy to the government to sell an increased amount of exports at a commercial loss. The total budgetary outlay is equal to {[P D ] 1 – [P W ] 1 } · [Q X ] 1, or s 0 · [Q X ] 1. The net effect of the export subsidy on the exporter is negative because there are DWLs and an income transfer from the exporting to the importing country.

8 Economic effects of an export subsidy Market analysis Analyzing the production, consumption and trade effects: the perspective of the importing country World marketImporter's domestic market

9 Economic effects of an export subsidy Economic intuition and expectations The application of an export subsidy results in an increase in the quantity exported (ES shifts to the right). It is assumed that the import-country's government has not taken any policy action to counter the subsidy. The world price decreases (  P W ) because a large seller on the international market increases the quantity supplied. The internal price in the importer's market is the world price because no policy action has been taken. Producers and consumers react to the change in the domestic price, from P W to [P W ] 1. Producers respond to price decreases by decreasing output,  Q S. In partial equilibrium analysis, a price decrease is expected to result in an increase in consumption,  Q D. Because the government has taken no action, there are no budgetary outlays or revenues collected on the imported good.

10 Economic effects of an export subsidy Welfare analysis Analyzing economic costs and income transfers among producers, consumers, traders and the government: the importing country's perspective Welfare analysis Δ CS Δ PS Δ G Δ NSW + ( ) - (1) + (2+3+4) 0 Importer's market

11 Economic effects of an export subsidy Economic interpretation of welfare areas Area '1' represents the value lost by producers and that is gained by consumers from the lower price; it is an income transfer from producers to consumers. Area '2' represents a loss to the economy from the reduction in production, the DWL in production. The DWL in production is the cost to society of reducing production as a result of world price being distorted. The reduced production reflects a misallocation of resources. Area '2+3+4' is the net welfare gain to the importer from a subsidy financed by the exporter, an international transfer from the export-country's government to the consumers as a result of the TOT effect.

12 Economic effects of an export subsidy Area '4' represents the cost to society from the increase in consumption, the DWL in consumption. The DWL in consumption in the importing country is the cost to society of consuming too much of the importable good as a result of distorted prices. The increased expenditures reflects a misallocation of resources (i.e., a sub-optimal consumption mix). The net effect of the export subsidy on the importing country is positive because the income transfer from the exporting country covers the cost of the DWLs. The total income transfer from the exporting country equals {[P W ] - [P W ] 1 } · [Q X ] 1. Once the DWLs (areas '2' + '4') are subtracted from the value of the transfer, the net result is (area '2' + '3' + '4').

13 Economic effects of an export subsidy Net world welfare effects Internal domestic transfers, DWLs and international transfers Exporter's marketImporter's market Δ NSW Importer Exporter World + (2+3+4) - (b+d) - (2+4) - (b+d) - (e+f+g+h+i) (2+3+4) = (e+f+g+h+i) - (2+4)

14 Economic effects of an export subsidy Concluding comments The export subsidy by a large country results in a TOT effect that affects importers and exporters differently: 1. A decrease in the world price benefits the importing country(ies) at the expense of the exporting country(ies) 2. The higher domestic price in the exporting country is a price support to producers which is paid by consumers and government. 3. The lower world price in the importing country is a subsidy to consumers, but a tax on producers, hurting the import-competing sector. 4. The international transfer, paid by the exporting country’s government, to the importing country is large enough to cover the costs of the DWLs from the policy, making the importing country better off. 5. The net effect of the export subsidy on the world economy is an international income transfer and a series of DWLs in production and consumption in both the importing and exporting country because prices have been distorted.