Feenstra Taylor Chapter 10

10 1
WTO Goals
2
Agricultural Export
Subsidies in Small Country
EXPORT SUBSIDIES IN 3
Agricultural Export
AGRICULTURE Subsidies
in Large Country
4
Agricultural Production
Subsidies
5
Introduction
• In December 2005, representatives of the 149

countries belonging to the WTO met in Hong
Kong to discuss reforms of the world trading
system.
• The main focus of these meetings was the trade
policy (tariffs and subsidies) on agricultural
products.
 Lower world prices hurt farmers in land-rich developing
countries like Brazil, India, and China.
 But lower world prices benefit land-poor developing
countries that import agricultural products.
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2 of 118

Introduction
• The first goal of this chapter is to explain agricultural

subsidy policies.
• The primary reason for agricultural export subsidies is

political.
• Examine how export subsidies can be used strategically

by governments to bolster domestic companies and
industries
 E.g. high-tech industries
• Legislators often believe that subsidies to high-tech

industries might raise their profits and benefit the exporting
countries.

WTO Goals on Agricultural Export Subsidies
• Agricultural Export Subsidies

 An export subsidy is a payment to a firm for every unit
exported.
 A fixed amount or a fraction of the sales price.
 Governments give subsidies to encourage domestic
firms to increase production in particular industries.
 Europe maintains a system of agricultural subsides

known as the Common Agricultural Policy (CAP).
 As a result, the sugar beet subsidy makes Europe a leading
supplier of sugar, even though other countries have a natural
comparative advantage over Europe.
 Other countries maintain similarly generous subsidies.
 U.S. pays cotton farmers to grow more cotton and subsidizes
agribusiness and manufacturers to buy the American cotton.

WTO Goals on Agricultural Export Subsidies
• Domestic Farm Supports

 These include any assistance given to farmers, even if it is not
directly tied to exports.
 These programs can still have an indirect effect on exports by
lowering production costs, and therefore the competitiveness, of
domestic products.
• Cotton Subsidies
 Export subsidies in cotton received special attention because that
crop is exported by many low-income African countries and is
highly subsidized in the U.S.
 Although the U.S. agreed to eliminate them, it still leaves open
other domestic supports to cotton not directly tied to exports.
• Let’s look at the effects of export subsidies on a “small”

country.
Agricultural Export Subsidies
in a Small Home Country
Figure 10.1 The free trade equilibrium at world price PW, gives
(without subsidy) exports of X1 and a horizontal Foreign import
demand. Equilibrium is at B.
Home World
Price Price
Home export
X
supply
D S
B
PW
Foreign import
demand
D1 S1 Quantity X1 Exports
X1

• Impact of an Export Subsidy
 Suppose the government wants to boost domestic
exports of sugar.
 Each ton of sugar exported receives a subsidy, s.
 Exporters will receive PW+s for each ton exported.

 Domestic price must rise to PW+s, otherwise firms will
not sell any output domestically.
 Home consumers could just import sugar at the world
price, PW.
 Therefore, Home will impose a tariff equal to or higher
than the amount of the export subsidy.
 This typically happens and, is therefore, realistic.

• Impact of an Export Subsidy
 The combined effect of the subsidy and the tariff is to
raise the price at Home.
 Exports increase due to two factors:

 Higher domestic price (movement along supply curve).
 Subsidy (shifts the export supply curve).
 Production and Consumption effects.
 As with a tariff, the subsidy has driven a wedge

between what domestic exporters receive (PW+s), and
what importers abroad pay (PW).

Figure 10.1 ThisHome
The decreases
exportdemand to D2, shifts
supply curve increases
downsupply to S2the
by exactly , and
(with subsidy) increases
amount
With exports
ofthe
the to Xthe
subsidy.
subsidy, . Equilibrium
2MC priceisrises
of production
Home atfalls
C.to by
PWexactly
+s s.
Home World
Price Price
X
D S X–s
C
PW+s
s B
PW
C'
s
D2 D1 X1 S1 S2 Quantity X1 X2 Exports
X2

• Impact of the Subsidy on Home Welfare
 The rise in price lowers consumer surplus by (a+b).
 The rise in price raises producer surplus by (a+b+c).
 The export subsidy costs the government the amount of

the subsidy, s, times the amount of exports, X2 shown
by (b+c+d).
 Adding up this impact, we are left with a net effect on

Home welfare of –(b+d).
 b is the production loss or efficiency loss for the economy.
 d is the consumer loss for the economy.

Figure 10.1 The increased price decreases consumer surplus by (a+b)
(with welfare effects) Producer surplus increases by (a+b+c)
The subsidy costs the government the amount –(b+c+d)
This leaves us with a deadweight loss of (b+d) as before.
Home World
Price Price
Total deadweight X
D S loss, b+d
X–s
b d C
PW+s
s a c B
PW
C'
s
D2 D1 S1 S2 Quantity X1 X2 Exports
X2

in a Large Home Country
• Now suppose Home is large enough that its
subsidy affects the world price of sugar.
 Foreign export demand curve, M*, is downward sloping.
• Note that the new world price, P*, is less than PW

although the new Home price is PW+s.
 Home terms of trade fall but foreign terms of trade rise.
• Since Home terms of trade fall, the Home country

will suffer overall losses.
• Foreign consumers will gain.

Figure 10.2 We begin in free trade equilibrium
(with subsidy) Home demand
applies adecreases
subsidy, shifting
and home
the export
supplysupply
increases
curve
leading
right by
to
the amountexports,
increased of the subsidy,
X2 s
The new world price is at new equilibrium, P*. New Home price is P*+s
(a) Home Market (b) World Market
Home World
Price Price
Home exports
S supply, X
D X2
P*+s
s X–s
X1
s PW
P*
Foreign
import
demand, M*

• Home Welfare
 The higher Home price reduces consumer surplus by
(a+b).
 Additionally, the higher price increases producer

surplus by (a+b+c).
 We also need to consider the cost of the subsidy—the

amount of the subsidy times the exports after the
subsidy, area (b+c+d+e).
 This gives a net welfare loss of (b+d+e).
 Area e represents the terms of trade loss.

Figure 10.2
Consumer surplus falls by -(a+b).
(with subsidy)
Producer surplus increases by +(a+b+c).
Home Welfare
Home The subsidy costs the government -
Price (b+c+d+e): subsidy times exports.
D S
b d This leaves a net deadweight loss
of (b+d+e), greater than in a small
P*+s
a c country.
s PW
e
P*
D2 D1 S1 S2 Quantity

• Foreign and World Welfare
 From Home’s perspective, the terms of trade loss is just
(e), but when we move to foreign welfare next, it will be
useful to break up (e) into the two parts e’ and f.
 The price of Foreign imports decreases leading to an
increase in Foreign consumer surplus by (e′).
 Combining Home welfare loss of (b+d+e) and
subtracting Foreign terms-of-trade gain (e′), there is an
overall deadweight loss for the world, (b+d+f) in panel b.
 The area (f) is the additional world deadweight loss due
to the subsidy.

Figure 10.2 World Consumer surplus rises by -(e’)
which
With Homeis a terms of trade
welfare loss ofgain
(b+d+e) and Foreign terms-of-trade
(without subsidy)
gain (e’),
f is an additional
there is World lossdeadweight
an overall due to decrease in Home’s
loss for terms
the world of of
trade not
(b+d+f) in completely
panel b offset by increases in World’s terms of trade

Home World
Price Price
Home exports
S supply, X
D b d b+d
P*+s
a c s X–s
s PW
e f
e'
P*
Foreign
import
demand, M*

• Foreign and World Welfare
 This transfer of terms of trade is what countries
sometimes use to make subsides sound like good
ideas to “aid” poorer countries.
 However, the deadweight loss (f) means using the
export subsidy to increase exports is an inefficient way
to transfer gains from trade among countries.
 It would be more efficient to just give cash aid to the
poorer countries.
 Cash does not change trade levels so would not have
deadweight loss of (b+d+f).
 This is why the European countries eliminated transfers of food
as a form of aid several years ago.

Who Gains and Who Loses?
APPLICATION
• Let’s return to the Hong Kong meeting of the
WTO in December 2005 to see which countries
will gain and which will lose when the export
subsidies are eliminated by 2013.
• Gains
 Obvious winners will be current agricultural exporters in
developing countries such as Brazil, Argentina,
Indonesia, and Thailand, along with potential exporters
such as India and China.
 These countries will gain even more when and if an
agreement is reached on eliminating agricultural tariffs
in the industrial countries.

APPLICATION
• Gains
 These actions will also benefit industrial countries,
suffering from deadweight losses and terms-of-trade
losses from the combination of subsidies and tariffs.
 Clearly the farmers in industrial countries who lose the
subsidies will be worse off.
 Given that it is usually the largest farmers who gain the most
from subsidy programs, they may be better able to adjust to the
elimination of subsidies than smaller farmers.

APPLICATION
• Losses
 Given that eliminating subsidies will typically lead to
increased world prices, food-importing countries,
typically the poorer non-food producing countries, will
lose.
 One study finds that the existing pattern of agricultural
supports raises the per-capita income of two-thirds of
77 developing nations, including most of the poorest
countries such as Burundi and Zambia.

APPLICATION
• Losses
 Figure 10.3 shows some of these results.
 Poor countries are net importers of essential food items
such as corn, rise, and wheat, and would be harmed by
an increase in their world price.
 Many of the world’s poorest individuals depend on
cereal crops for much of their diet and would be
especially hard hit by any increase in those prices.

APPLICATION
Figure 10.3

APPLICATION
Figure 10.3

Agricultural Production Subsidies
• The agreements reached in Hong Kong

distinguish between export subsidies in
agriculture and all other forms of domestic support
that increase production.
 Tax incentives and other types of subsidies
• This is because it is expected that these other
forms have less impact on exports than do direct
subsidies.
• In this section, therefore, we will examine the
impact of a production subsidy in agriculture for
both a small and a large country.

• A production subsidy is when the government

provides a subsidy of s dollars for every unit that a
Home firm produces.
 It is a subsidy to every unit produced, not just to units
exported.
• The subsidy can be implemented by the

government:
 guaranteeing a minimum price to the farmer.
 providing subsidies to the users of the crop to purchase
it, thereby increasing demand for the crop and the
price.

• These policies all fall under Article XVI of the

GATT.
• This states that partner countries should be

notified of the extent of such subsidies, and where
possible, these subsidies should be limited.
• In Hong Kong, the WTO members further agreed

to classify countries according to the extent of
such subsidies.

• Effect of a Production Subsidy in a Small Home

Country
 We have a small country with a fixed world price of PW.
 There is a subsidy of s increasing Home price to
producers to PW+s.
 Quantity demanded at home does not change since
producers still charge the world price at Home.
 This happens because Home producers receive the
subsidy no matter who they sell to.
 The production subsidy increases exports by less than
an export subsidy.

Figure 10.4 Subsidy
We can increases
see in (b) price to producers
that Home increasing
export supply supply to
increases,
S-s producing
showing S2. Home
that exports quantity
increase demanded
from X1 to X2. does
This not
is a
(with production change.
smaller increase than with an export subsidy since Home
subsidy) demand does not change.

Home World
Price Price
X
D X’
S S-s
C
PW+s
s B
PW C'
D1 S1 S2 Quantity X1 X2 Exports

• Home Welfare
 Producer surplus rises by (a+b) in panel a.
 Government cost of the subsidy is (a+b+c) – the
amount of subsidy s times total production S2.
 Consumer surplus is unaffected since quantity
demanded is unaffected.
 This leaves a new effect on Home welfare of (–c).
 The deadweight loss caused by the production subsidy,
(c), is less than that caused by the export subsidy,
(b+d).
 The only deadweight loss is in production inefficiency—
producers produce at higher than marginal cost.

Figure 10.4 Home producer surplus rises by (a+b)
(with welfare effects) Subsidy costs government (a+b+c)
Deadweight loss from production subsidy is c, which is less
than with export subsidy of (b+d) in figure 10.1.

Home World
Price Price
X
D X’
S S-s
C
PW+s
s a b
c B
PW C'

• Targeting Principle
 Since the deadweight loss is lower for this subsidy than
for the export subsidy, it makes a better policy
instrument for the purpose of increasing Home supply.
 This is an example of the targeting principle.

 To achieve some objective, it is best to use the policy
instrument that achieves the objective most directly.
 To use an example from this book, it is better to provide

trade adjustment assistance directly to those affected,
than to impost a tariff or quota.

• Effect of Production Subsidy in a Large Home

Country
 We will not draw this case in detail but will use figure
10.4 to briefly explain.
 Price rises from PW to PW+s, and Home production

increases to S2.
 Since demand has not changed, exports increase by

the same amount as the change in Home supply.
 The rise in exports from B to C′ is less than the

increase in exports with an export subsidy, from B to C.

Production Subsidy for a Large Home Country
This increase
Thesee
We this asinan
production exports
subsidy (B to
inC′)
leads
increase to is
the less than
increase
export we curve
saw
in price
supply with
to P W +san export
from X to X’
subsidy
changing (B to
and increased C).productionfrom
the equilibrium to SB2 increasing
to C’ exports by S1-S2
Home World
Price Price
X
D X’
S S-s
C
PW+s
s
B
PW C'
ΔX

• Effect of Production Subsidy in a Large Home

Country
 In the export supply subsidy, the increase in exports
occurred due to the increase in supply and the
decrease in demand.
 The export supply curve shifted down by the exact amount of
the subsidy, s, (as in figure 10.1).
 With a production subsidy, the exports increased only due to
the increase in Home production.
 The export supply curve then shifted down by an amount less
than s, (as in figure 10.4).

• Effect of Production Subsidy in a Large Home Country
 If we draw a downward-sloping foreign import demand curve
in panel b, then the increase in supply due to the production
subsidy would lower the world price.
 But the drop in world price would be less than the drop that
occurred with the export subsidy, since the increase in
exports is less.
• Production subsidies in agriculture still lower world prices,

but by less than export subsidies.
• Therefore, the WTO is less concerned about eliminating

production subsidies and other forms of domestic support
for agriculture.

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10 1

• In December 2005, representatives of the 149

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2 of 118

• The first goal of this chapter is to explain agricultural

• The primary reason for agricultural export subsidies is

• Examine how export subsidies can be used strategically

• Legislators often believe that subsidies to high-tech

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 3 of 118

• Agricultural Export Subsidies

 Europe maintains a system of agricultural subsides

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 4 of 118

• Domestic Farm Supports

• Let’s look at the effects of export subsidies on a “small”

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 6 of 118

 Exporters will receive PW+s for each ton exported.

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 7 of 118

 Exports increase due to two factors:

 Production and Consumption effects.

 As with a tariff, the subsidy has driven a wedge

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 8 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 9 of 118

 The rise in price raises producer surplus by (a+b+c).

 The export subsidy costs the government the amount of

 Adding up this impact, we are left with a net effect on

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 10 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 11 of 118

• Note that the new world price, P*, is less than PW

• Since Home terms of trade fall, the Home country

• Foreign consumers will gain.

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 12 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 13 of 118

 Additionally, the higher price increases producer

 We also need to consider the cost of the subsidy—the

 This gives a net welfare loss of (b+d+e).

 Area e represents the terms of trade loss.

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 14 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 15 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 16 of 118

(a) Home Market (b) World Market

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 17 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 18 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 19 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 20 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 21 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 22 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 23 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 24 of 118

• The agreements reached in Hong Kong

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 25 of 118

• A production subsidy is when the government

• The subsidy can be implemented by the

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 26 of 118

• These policies all fall under Article XVI of the

• This states that partner countries should be

• In Hong Kong, the WTO members further agreed

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 27 of 118

• Effect of a Production Subsidy in a Small Home

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 28 of 118

(a) Home Market (b) World Market

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 29 of 118

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 30 of 118

(a) Home Market (b) World Market

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 31 of 118