A large firm exports from your country A to country C. The only competitor is a

Question

A large firm exports from your country A to country C. The only competitor is a firm producing, in country B, an imperfect substitude product for export to the same market in C. The demand, in C, for both productions diminishes with the price charged. Outline the circumstances (if any) under which you would recommand that your country's government should subsidize (or tax) this export. (Note that staring your answer in algebra is not sufficient. You must make it clear, in words, that you understand any results)

Explanation / Answer

Introducing a subsidy or some other government measure within a perfect market framework will be inefficient and welfare-diminishing. But if the perfect market assumption is relaxed, situations may arise where a government measure like a subsidy improves welfare. An efficient subsidy would correct a market failure, bringing social and private costs and benefits into alignment.

Suppose that a government decided to protect a particular domestic industry on the grounds that there were learning-by-doing effects associated with the activity from which the wider economy would benefit, and that these benefits were not properly reflected by the market. In this case, a government might choose between imposing a tariff on competing imports or directly subsidizing the industry concerned. A tariff would raise the domestic price of imports and allow the protected industry’s output price to rise to the same level. Domestic consumers would then have to pay the higher price. But if a subsidy were used, the domestic price would still be the duty-free import price, and the subsidy received by the domestic industry would allow it to compete with imports at world prices. Consumers would not be taxed, and the subsidy option would be regarded as the more efficient one. This is an application of the theory of optimal intervention

Point to key distinction in terms of the incidence of two types of subsidies – export subsidies and production subsidies. Export subsidies are contingent upon exports only and will have different resource allocation and efficiency implications than production subsidies. Production subsidies apply to output regardless of its market destination, but they can also affect exports.

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