Many countries subsidize some of their export industries. Use a partial equilibrium model under perfect competition to illustrate the following effects of an export subsidy for a large country:

Impact on the Domestic Market

Let's consider a large country exporting good X. Initially, the domestic market is in equilibrium where the supply curve (S) intersects the demand curve (D) at price P₀ and quantity Q₀. With a perfectly competitive market, firms are price takers. An export subsidy of 't' per unit is introduced. This effectively increases the price received by exporters for every unit sold abroad.

The subsidy shifts the supply curve upwards by the amount of the subsidy (S + t). This is because producers are now willing to supply the same quantity at a lower price, or a larger quantity at the same price, due to the subsidy. The new equilibrium in the domestic market is at price P₁ (which is lower than P₀) and quantity Q₁ (which is higher than Q₀). The difference between Q₁ and Q₀ represents the increase in domestic production due to the subsidy.

Impact on the World Market

Before the subsidy, the country was exporting a quantity determined by the difference between domestic production and domestic consumption. After the subsidy, domestic production increases (as shown above). Assuming domestic demand remains constant in the short run, the increase in production is exported to the world market. This increases the world supply of good X.

In the world market, the large country’s increased supply leads to a decrease in the world price from P_w0 to P_w1. The magnitude of the price decrease depends on the elasticity of world demand. A more elastic demand will result in a larger price decrease. The country’s exports increase from Q_w0 to Q_w1.

Welfare Analysis

The welfare effects of the export subsidy are complex and involve gains and losses for different groups:

• Consumers: Consumers benefit from the lower domestic price (P₁ < P₀). This leads to an increase in consumer surplus.
• Producers: Producers benefit from both the higher quantity sold (Q₁ > Q₀) and the price they receive (P₁ + t > P₀). This leads to an increase in producer surplus.
• Government: The government incurs a cost equal to the subsidy amount multiplied by the quantity exported (t * Q_w1). This represents a loss to the government budget.
• World Consumers: Consumers in importing countries benefit from the lower world price (P_w1 < P_w0).

The net welfare effect for the exporting country is ambiguous. While consumers and producers gain, the government loses. The overall effect depends on the relative magnitudes of these gains and losses. Generally, for a large country, the gains to producers and consumers may outweigh the government’s cost, leading to a net welfare gain. However, this is not always the case, especially if the subsidy is large and the domestic demand is relatively inelastic.

It's important to note that the welfare effects are static. Dynamic effects, such as increased innovation or economies of scale, are not considered in this partial equilibrium model.

Graphical Representation (Conceptual)

While a diagram cannot be directly rendered here, imagine two diagrams:

• Diagram 1 (Domestic Market): Downward sloping demand and supply curves. The original equilibrium is at P₀, Q₀. The supply curve shifts upwards by 't' to S+t, resulting in a new equilibrium at P₁, Q₁.
• Diagram 2 (World Market): Downward sloping world demand curve. The country’s supply curve shifts outwards, leading to a decrease in the world price from P_w0 to P_w1 and an increase in quantity exported.