Classical trade theory, which is based upon the assumption of perfect competition, fails to pro-vide an explanation for the incentives which cause a welfare maximising government to imple-ment an export subsidy policy (Collie, 2000). This is due to the loss in terms of trade incurred bythe exporting country
. Furthermore, a deadweight loss is imposed upon the rest of the world.In contrast, new trade theory, which encompasses imperfect competition, does provide anincentive for an exporting country to implement a subsidy in the form of profit-shifting
(Brander and Spencer, 1985). Imperfect competition is the result of market failure. In contrast to perfectcompetition, there is the possibility to earn monopoly profits in the short-run (Feenstra and Tay-lor, 2008). This type of market structure is conducive to the emergence of strategic trade policyas firms compete for monopoly rents. Although, the exporting country increases it's welfare it isat the expense of competing foreign countries. This type of trade policy may be referred to as a beggar-thy-neighbour strategy. Upon the conclusions of this new theory, individual sectors andcountries may benefit but a multi-lateral elimination of such subsidies would increase world wel-fare through the removal of the deadweight loss.Arguments put forward for the implementation of export subsidies are to expand exports, preserve a country’s international market share and to diversify economic activity. These aimscan be motivated by pressure from interests groups, as in the case of agricultural export subsidiesin the European Union. Diversification is a particularly attractive prospect in developing coun-tries
.However, empirical studies, which will be discussed later in the essay, show that the re-sults of export subsidisation often do not outweigh the costs (Panagariya, 1999). There are many3
In classical trade theory models such as the Ricardian model, both domestic and foreign countries gain from tradeand the terms of trade of both countries increase.
An illustration of which will be shown later in the essay.
Diversification reduces the dependence of these economies on a small number of industries.