Download Export Subsidies in Agriculture and High

10
EXPORT SUBSIDIES IN
AGRICULTURE AND
HIGH-TECHNOLOGY
INDUSTRIES
1
WTO Goals
2
Agricultural Export
Subsidies in Small Country
3
Agricultural Export
Subsidies
in Large Country
4
Agricultural Production
Subsidies
5
High-Tech Export
Subsidies
6
Conclusions
Chapter Outline
• Agricultural Export Subsidies in a Small Home
country
 Impact of an Export Subsidy
 Impact of the Subsidy on Home Welfare
• Agricultural Export Subsidies in a Large Home
Country
 Effect of the Subsidy
 Home Welfare
 Foreign and World Welfare
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Chapter Outline
• Agricultural Production Subsidies
 Effect of a Production Subsidy in a Small Home
Country
 Home Welfare
 Targeting Principle
 Effect of the Production Subsidy in a Large Home
Country
• High-Technology Export Subsidies
 “Strategic” use of High-Tech Export Subsidies





Payoff Matrix
Nash Equilibrium
Best Strategy for Boeing
Best Strategy for Airbus
Multiple Equilibria
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Chapter Outline
 Effect of a Subsidy to Airbus




Best Strategy for Airbus
Best Strategy for Boeing
Nash Equilibrium
European Welfare
 Subsidy with Cost Advantage for Boeing




Best Strategy for Airbus
Best Strategy for Boeing
European Welfare Once Again
Summary
• Conclusions
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Learning Objectives
• Understand what an export subsidy is.
• Understand agricultural subsidy policies.
• Understand subsidies in the high-technology
industry.
• Understand how export subsidies can be used
strategically by governments.
• Understand the effects of export subsidies on
prices, the amount of trade, and welfare.
• Know how to use game theory to model strategic
interactions between firms.
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Learning Objectives
• Understand what a production subsidy is.
• Understand the difference between an export
subsidy and a production subsidy.
• Understand the effect of a production subsidy on
prices, the amount of trade, and welfare.
• Understand why the WTO is focused more on
eliminating export subsidies and less on
production subsidies.
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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.
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Introduction
• The first goal of this chapter is to explain agricultural
subsidy policies.
• The primary reason for agricultural export subsidies is
political.
• However, the fact that these subsidies are costly to
those governments, and to exporters of land-rich
developing countries, has led to pressures in the
Doha round of WTO negotiations to remove them.
• We will describe the tentative agreements to reduce
agricultural subsidies made at the 2005 Hong Kong
meeting, as part of the Doha round.
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Introduction
• The second goal of this chapter is to 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 hightech industries might raise their profits and benefit
the exporting countries.
• Using the tools we have developed up to now, we
examine the effects of export subsidies on prices,
the amount of trade, and welfare.
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WTO Goals on Agricultural Export Subsidies
• Table 10.1 describes the agreements made at the
Hong Kong meeting of the WTO.
• These have not been ratified by the legislatures in
the countries involved so they are goals rather
than outcomes.
• 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.
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WTO Goals on Agricultural Export Subsidies
Table 10.1
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WTO Goals on Agricultural Export Subsidies
Table 10.1 cont.
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WTO Goals on Agricultural Export Subsidies
• Agricultural Export Subsidies
 Member countries of the WTO agreed to abolish all
export subsidies by the end of 2013.
 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.
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WTO Goals on Agricultural Export Subsidies
• Agricultural Export Subsidies
 In Geneva, in July 2004, member countries agreed in
principle to cut their export subsidies in agriculture, but
slow progress has been made.
 At about the same time, several agricultural exporters,
led by Brazil, brought a WTO case against sugar
subsidies in Europe and cotton subsidies in the U.S.
 The WTO ruled in favor of Brazil in 2004, which also
won appeals brought by Europe and the U.S.
 The favorable ruling created additional pressure for the
Hong Kong talks.
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WTO Goals on Agricultural Export Subsidies
• Indirect Subsidies
 Included in the Hong Kong agreements is the parallel
elimination of indirect subsidies to agriculture,
including food aid from developed countries to poor
countries.
 Europe has already eliminated direct food subsidies
and argues that cash aid to poor countries is much
more effective.
 The U.S. continues to export agricultural commodities
as aid.
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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.
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Brazil Wins Rulings on Two Trade Issues
HEADLINES
• The WTO ruled that the European Union’s sugar
subsides and the U.S.’s cotton subsidies are
illegal and violate the organization's rules.
• This was a big victory for Brazil in their fight
against farm aid in developing nations.
• These disputes are part of efforts by developing
and food exporting nations to influence wealthy
governments to cut spending on farmers.
• Both the U.S. and the EU plan on appealing the
decision.
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Brazil Wins Rulings on Two Trade Issues
HEADLINES
• If the decision is upheld on appeal, it would force
the U.S. to change its farm-payment legislation.
• This could also cause a number of other countries
to follow Brazil in submitting cases to the WTO.
• If the decision is implemented by the U.S., cotton
farmers will be hurt and may have to find other
crops to plant.
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WTO Goals on Agricultural Export Subsidies
• Other Matters From the Hong Kong WTO Meeting
 Another issue discussed is the use of tariffs as a
response to another country’s subsidies.
 As we know, tariffs depress world prices, as do
subsidies, so eliminating both is desirable.
 Subsidies also relate to other items on the WTO
agenda, such as protectionist policies in the services
sector.
 This becomes part of the negotiation trade off that
occurs in WTO negotiations.
 Richer countries will trade off reductions in subsidies for
access to service markets in poorer countries.
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WTO Goals on Agricultural Export Subsidies
• Countervailing Tariffs in Agriculture
 Whenever subsidies are used, exporting countries
expect countervailing duties to be applied.
 Agriculture exporting developing countries tried to get
these reduced, but were not successful in Hong Kong.
• Issues Involving Trade in Industrial Goods and
Services.
 Although there was agreement to achieve further cuts
in the tariffs on industrial goods, the exact nature of the
formula to be used has yet to be decided.
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WTO Goals on Agricultural Export Subsidies
• Issues Involving Trade in Industrial Goods and
Services
 There was also an agreement to discuss opening trade
in the services sectors, which would benefit
industrialized countries.
 The developing countries are expected to make some
offer to open their market to trade in services.
 However, this is likely to lead to an expectation that
wealthy countries accept more temporary immigrant
workers in their service sectors.
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WTO Goals on Agricultural Export Subsidies
• Issues Involving Trade in Industrial Goods and
Services
 Finally, there was an agreement to allow tariff-free
access to WTO member markets for 97% of imported
products from the world’s 50 least-developed countries
(LDCs).
 The U.S. already has this for 83% of products.
 Omitted from this, however, are textile imports into the
U.S. from LDCs.
 U.S. wants to protect its domestic textile producers.
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Agricultural Export Subsidies
in a Small Home Country
• We now want to look at the effects of export
subsidies on a country.
• We start with a small Home country.
 Faces a fixed world price for its export.
• Country will export sugar.
• No trade equilibrium is shown in figure 10.1 at
point A.
 World price of PW, Home quantity supplied at S1,
quantity demanded at D1, and exports X1=S1-D1.
• Quantity of exports is point B in panel b at free
trade price of PW and export supply curve, X.
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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
Price
World
Price
S
D
Home export
supply
X
B
PW
Foreign import
demand
A
D1
X1
S1
Quantity
X1
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Exports
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Agricultural Export Subsidies
in a Small Home Country
• 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.
 They are allowed to export all they want at the
subsidized price and Home firms will not accept a price
less than PW+s.
 If domestic price was lower than PW+s, the firms would just
export their goods instead.
 Therefore, the domestic price must rise to PW+s.
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Agricultural Export Subsidies
in a Small Home Country
• Impact of an Export Subsidy
 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.
 The combined effect of the subsidy and the tariff is to
raise the price at Home.
 Price is PW+s, Home supply increases to S2, Home
demand falls to D2, Home exports increase to X2=S2D2.
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Agricultural Export Subsidies
in a Small Home Country
• Impact of an Export Subsidy
 The change in the quantity of exports can be thought of
in two ways reflected by points C and C’ in panel b.
 If we measure Home price PW on the vertical axis, C is
on the original Home export supply curve, showing a
movement along the curve.
 As the Home price has increased, the quantity of Home exports
has increased from B to C.
 If we use the vertical axis as world price, which is fixed
in our small country, the increase in exports due to the
subsidy can be interpreted as a shift of the domestic
export supply curve – point C′.
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Agricultural Export Subsidies
in a Small Home Country
Figure 10.1
(with subsidy)
ThisHome
decreases
to D2, shifts
increases
to S2the
, and
The
exportdemand
supply curve
downsupply
by exactly
increases
exports
to Xthe
. Equilibrium
atfalls
C.to by
amount
ofthe
the
subsidy.
of production
s.
With
subsidy,
Home
priceisrises
PWexactly
+s
2MC
Home
Price
World
Price
X
S
D
X–s
C
PW+s
B
s
PW
C'
s
A
D2 D1
X1
X2
S1 S2 Quantity
X1
X2
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Exports
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Agricultural Export Subsidies
in a Small Home Country
• Impact of an Export Subsidy
 Export subsidies increase both the price and quantity of
exports.
 A movement along the domestic export supply curve.
 For the world perspective, the export subsidy results in
an increase in export supply.
 Given the fixed world price, this means the export
supply curve shifts down by the amount of the subsidy,
s.
 As with a tariff, the subsidy has driven a wedge
between what domestic exporters receive (PW+s), and
what importers abroad pay (PW).
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Agricultural Export Subsidies
in a Small Home Country
• 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).
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Agricultural Export Subsidies
in a Small Home Country
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
Price
World
Price
S
D
b
Total deadweight
loss, b+d
d
a
X–s
C
PW+s
s
X
B
c
PW
C'
s
A
D2 D1
X2
S1 S2
Quantity
X1
X2
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Exports
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Agricultural Export Subsidies
in a Small Home Country
• Impact of the Subsidy on Home Welfare
 The deadweight loss due to the subsidy in a small
country is similar to the effects of a tariff.
 Areas b and d have particular meanings.
 Triangle d equals the increase in marginal costs for the
extra unit produced due to the subsidy.
 This is the production loss or efficiency loss for the economy.
 Triangle b is the drop in consumer surplus for those
who no longer get to the consumer.
 This is the consumer loss for the economy.
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Agricultural Export Subsidies
in a Large Home Country
• Now suppose Home is large enough that its
subsidy affects the world price of sugar.
• Figure 10.2 shows the effects of the subsidy.
• The Foreign export demand curve, M*, is
downward sloping since changes in the amount
exported will affect world price.
• As before, in free trade, Home and world price is
PW, Home exports X1=D1-S1.
• The world export market is in equilibrium where
Home export supply, X, and foreign import
demand curve, M*, cross.
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Agricultural Export Subsidies
in a Large Home Country
• Effect of the Subsidy
 Home applies a subsidy, s.
 The Home export supply curve shifts right by the
amount of the subsidy, X-s.
 The new intersection with the Foreign import demand
gives a new equilibrium at P* and X2.
 Price is lower and exports are higher.
 Note that the new world price, P*, is less than PW
although the new Home price is PW+s.
 Since Foreign consumers pay a lower price for Home
exports, Home terms of trade fall but foreign terms of
trade rise.
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Agricultural Export Subsidies
in a Large Home Country
• Effect of the Subsidy
 Since Home terms of trade fall, the Home country will
suffer overall losses.
 Foreign consumers will gain.
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Agricultural Export Subsidies
in a Large Home Country
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
Price
World
Price
D
Home exports
supply, X
S
X2
P*+s
s
X1
s
X–s
PW
P*
Foreign
import
demand, M*
D2 D1
S1 S2
Quantity
X1
X2
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Exports
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Agricultural Export Subsidies
in a Large Home Country
• Home Welfare
 We can see the welfare effects of the subsidy in figure
10.2.
 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).
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Agricultural Export Subsidies
in a Large Home Country
Figure 10.2
Consumer surplus falls by -(a+b).
(with subsidy)
Producer surplus increases by +(a+b+c).
Home Welfare
The subsidy costs the government (b+c+d+e): subsidy times exports.
Home
Price
D
b
d
S
This leaves a net deadweight loss
of (b+d+e), greater than in a small
country.
P*+s
c
a
s
PW
e
P*
D2 D1
S1 S2
Quantity
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Agricultural Export Subsidies
in a Large Home Country
• Home Welfare
 In a small country, the deadweight loss associated with
the subsidy is only (b+d).
 In a large country, there is an additional deadweight
loss, (e), which is from the terms of trade loss to Home:
e = e’ + f in panel b.
 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.
 Due to a reduction in the world price of its exported
good, a large country loses even more from a subsidy
than a small country.
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Agricultural Export Subsidies
in a Large Home Country
• Foreign and World Welfare
 While Home definitely loses, Foreign definitely gains.
 Figure 10.2 panel b shows the welfare effects from the
subsidy.
 The price of Foreign imports decreases leading to an
increase in Foreign consumer surplus by (e′).
 The fall in the price of Foreign imports also improves
Foreign’s terms of trade.
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Agricultural Export Subsidies
in a Large Home Country
• Foreign and World Welfare
 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.
 This arises from the terms-of-trade loss in Home which
is not completely offset by the terms-of-trade gain in
Foreign.
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Agricultural Export Subsidies
in a Large Home Country
Figure 10.2
World Consumer surplus rises by -(e’)
which
is a terms
of trade
gain
With Home
welfare
loss of
(b+d+e) and Foreign terms-of-trade
gain
(e’),
there is World
an overall
loss for
the world
of of
f is an
additional
lossdeadweight
due to decrease
in Home’s
terms
(b+d+f)
in completely
panel b
trade not
offset by increases in World’s terms of trade
(without subsidy)
(a) Home Market
(b) World Market
Home
Price
World
Price
D
b
d
S
Home exports
supply, X
b+d
P*+s
c
a
s
s
PW
e
X–s
f
e'
P*
Foreign
import
demand, M*
D2 D1
S1 S2
Quantity
X1
X2
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Exports
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Agricultural Export Subsidies
in a Large Home Country
• 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.
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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.
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Who Gains and Who Loses?
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.
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Who Gains and Who Loses?
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.
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Who Gains and Who Loses?
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.
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Who Gains and Who Loses?
APPLICATION
Figure 10.3
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Who Gains and Who Loses?
APPLICATION
Figure 10.3
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Who Gains and Who Loses?
APPLICATION
• Food Aid
 What about indirect subsidies like food aid?
 The U.S. is still a principle supplier of food aid.
 This is for humanitarian purposes and to eliminate surplus
commodities at Home.
 There is clearly a need for donations of food in cases of
true food shortages.
 However, the U.S. also provides food aid shipments to
areas without shortages.
 This can decrease local prices and harm local producers.
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Who Gains and Who Loses?
APPLICATION
• Food Aid
 European countries argue that it is better to have
United Nations relief agencies buy food from local
farmers in poor regions and then distribute it as
needed.
 This boosts production in the poor country and helps
feed its poorest citizens.
 The EU insisted on the elimination of indirect subsidies
to regions without shortages by 2013, along with direct
export subsidies.
 The goal has not yet been implemented.
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Who Gains and Who Loses?
APPLICATION
• While this was being discussed in Hong Kong, several
U.S. agencies placed an advertisement in the Financial
Times.
• A response from Peter Mandelson, the European
Commissioner for Trade, and Marian Fisher Boel, the
European Commissioner for Agricultural and Rural
Development, was also published in the Financial Times.
• That letter was followed a week later by a letter response
from the United Nations World Food Programme.
• These exchanges make it clear the complexity of
negotiations, where emotions run high, in the Doha Round.
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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.
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Agricultural Production Subsidies
• A production subsidy is when the government
provides a subsidy of s dollars for every unit (for
example, tons of sugar) 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.
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Agricultural Production Subsidies
• 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.
• Table 10.1, described earlier, shows level of
production subsidies for different countries.
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Agricultural Production 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.
 Home quantity supplied increases from S1 to S2.
 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.
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Agricultural Production Subsidies
• Effect of a Production Subsidy in a Small Home
Country
 This contrasts with an export subsidy where Home
firms only receive the subsidy for export sales and must
sell to Home at the higher export price.
 You can see these effects in figure 10.4.
 The production subsidy increases exports to X2 = S2 –
D1.
 The production subsidy increases exports by less than
an export subsidy.
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Agricultural Production Subsidies
Figure 10.4
(with production
subsidy)
Subsidy
to producers
increasing
supply to
We can increases
see in (b) price
that Home
export supply
increases,
S-s
producing
S2. Home
quantity
demanded
showing
that exports
increase
from
X1 to X2. does
This not
is a
change.
smaller increase than with an export subsidy since Home
demand does not change.
(a) Home Market
(b) World Market
Home
Price
World
Price
X
D
S
S-s
X’
C
PW+s
s
B
PW
C'
D1
S1 S2
Quantity
X1 X2
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Exports
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Agricultural Production Subsidies
• 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.
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Agricultural Production Subsidies
Figure 10.4
(with welfare effects)
Home producer surplus rises by (a+b)
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.
(a) Home Market
(b) World Market
Home
Price
World
Price
X
D
S
S-s
C
PW+s
a
s
X’
b
PW
B
c
C'
D1
S1 S2
Quantity
X1 X2
© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor
Exports
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Agricultural Production Subsidies
• 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.
 There are many examples of using a targeting principle
in economics:
 Taxes on cigarettes and gasoline.
 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.
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Agricultural Production Subsidies
• 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.
 This is shown by the outward shift in the export supply
curve from X to X′ in Panel b.
 The rise in exports from B to C′ is less than the
increase in exports with an export subsidy, from B to C.
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Agricultural Production Subsidies
Production Subsidy for a Small Country Large Home Country
W +san export
This
increase
exports
(B
to
less than
we curve
saw
with
Thesee
production
subsidy
leads
to is
increase
in price
to P
We
this asinan
increase
inC′)
the
export
supply
from
X to X’
subsidy
(B
to
C).
and increased
productionfrom
to SB2 increasing
exports by S1-S2
changing
the equilibrium
to C’
(a) Home Market
(b) World Market
Home
Price
World
Price
X
D
S
S-s
X’
C
PW+s
s
B
PW
C'
ΔX
D1
S1 S2
Quantity
X1 X2
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Exports
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Agricultural Production Subsidies
• 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).
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Agricultural Production Subsidies
• 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.
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Agricultural Production Subsidies
• 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.
• These other policies have a smaller impact on
world prices and a smaller deadweight loss as
compared to export subsidies.
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High-Technology Export Subsidies
• We now change focus from agriculture to hightechnology products.
• The high-tech sector also receives substantial
subsides from the government.
 An example being subsidies to the aircraft industries in
both the U.S. and Europe.
• In the U.S., subsidies take the form of low-interest
loans provided by the Export-Import Bank.
 The Export-Import Bank is a U.S. government agency
that finances export related projects.
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High-Technology Export Subsidies
• On the European side, support for R&D and other
subsidies are given to Airbus directly by the
government.
 Airbus produces parts and assembles its finished
product in a number of European countries.
• Japan and South Korea give direct subsidies to
high-tech manufacturing firms and reach certain
targets for export sales.
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High-Technology Export Subsidies
• Another reason that some governments support
high-tech industries is because of the possible
spillover benefits to other areas of the economy.
• Governments believe there is a positive
externality that exists from the production of hightech products, so subsidizing them increases
production and minimizes the externality.
• This is similar to the infant industry argument for
tariffs, but is applied to an export instead of an
import.
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High-Technology Export Subsidies
• “Strategic” Use of High-Tech Export Subsidies
 Governments argue subsidies might give a
strategic advantage to export firms competing with
a small number of rivals in international markets.
 If high-tech subsidies allow firms to compete more
effectively and earn more profits in the international
market, and if extra profits are greater than the
subsidy, then the exporting country has an overall
gain.
 This is similar to the benefit a large country can get
from a tariff.
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High-Technology Export Subsidies
• “Strategic” Use of High-Tech Export Subsidies
 We will use an assumption of imperfect competition
to examine this issue.
 We allow for 2 firms in the market—a duopoly.
 Each firm can set the price and quantity of its
output based on the price and quantity decisions of
the other firm.
 We then examine the effects of strategic export
subsidies in determining whether the profits of the
exporting firm will rise enough to offset the cost of
the subsidy to the government.
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High-Technology Export Subsidies
• “Strategic” Use of High-Tech Export Subsidies
 To capture strategic decision making of two firms,
we will use game theory.
 The modeling of strategic interactions (games) between
firms as they choose actions that will maximize their
returns.
 The goal is to model the strategic interactions of
high-tech firms in Home and Foreign, and then see
the impact of export subsidies on their respective
decisions and payoffs.
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High-Technology Export Subsidies
• “Strategic” Use of High-Tech Export Subsidies
 We begin with free trade.
 Two firms are competing for sales of a new type of
aircraft.
 We will focus on the decision of each firm to develop
the new aircraft, that competes with the aircraft of the
other firm for sales to the rest of the world.
 We will ignore sales in their own countries, so we do
not have to keep track of consumer surplus.
 Welfare is only dependent on the profits earned by
Boeing or Airbus from sales to the rest of the world.
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“Strategic” Use of High-Tech
Export Subsidies
• Payoff Matrix
 Figure 10.5 shows a payoff matrix for Boeing and
Airbus.
 Each producer must decide whether or not to produce
the new aircraft.
 Each quadrant of the matrix shows the profit earned by
Boeing in the lower-left corner.
 The profits of Airbus are in the upper-right corner.
 When both firms produce (upper left quadrant), their
prices are reduced through competition, and both end
up making negative profits of $5 million.
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“Strategic” Use of High-Tech
Export Subsidies
• In the top right quadrant
 Airbus is not producing: profits $0.
 Boeing is producing: profits $100 million.
• In the bottom left quadrant
 Airbus is producing: profits $100 million.
 Boeing is not producing: profits $0.
• In the bottom right quadrant
 Neither firm is producing.
 Profits for both are $0.
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“Strategic” Use of High-Tech
Export Subsidies
Figure 10.5
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“Strategic” Use of High-Tech
Export Subsidies
• Nash Equilibrium
 We want to determine the outcome of this game
between the two firms.
 We use the concept of the Nash Equilibrium.
 Each firm must make its own best decision, taking as a given
each possible action taken by the rival firm.
 That is, the action of each player is the best possible response
to the action of the other player.
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“Strategic” Use of High-Tech
Export Subsidies
• Best Strategy for Boeing
 What are Boeing’s possible strategies if Airbus chooses
to produce?
 To find this, we look only at the column where Airbus is
producing and see where Boeing is better off.
 In this case, Boeing is clearly better off not producing.
 This gives a profit of $0, rather than a profit of -$5 million
 This tells us that BOTH firms NOT producing is NOT a
Nash Equilibrium.
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“Strategic” Use of High-Tech
Export Subsidies
• Best Strategy for Airbus
 What if Boeing does not produce? What is the best
strategy for Airbus?
 We now look only at the bottom row of the matrix where
Boeing is not producing.
 In this case, it is clear that Airbus is better off producing
with a profit of $100 million versus $0.
 Therefore, we have a Nash Equilibrium when Airbus
produces and Boeing does not.
 Each firm is making its best decision given what the other firm
is doing.
 The bottom left square is a Nash Equilibrium.
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“Strategic” Use of High-Tech
Export Subsidies
• Multiple Equilibria
 Is it possible to have more than one Nash Equilibrium?
 What if Boeing decides to produce first.
 We can then look at the top row and see that Airbus’
best strategy is to not produce.
 If Airbus does not produce, looking at the last column of
the matrix, Boeing’s best strategy is to produce.
 Therefore, the top right-hand box, with Boeing
producing and Airbus not producing, is also a Nash
Equilibrium.
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“Strategic” Use of High-Tech
Export Subsidies
• Multiple Equilibria
 When there are two Nash equilibria, then there must be
some force that determines which one we are in.
 One of these is the first mover advantage.
 One firm is able to decide whether or not to produce before the
other firm.
 Suppose we start at the Nash equilibrium in the upperright quadrant.
 Because Airbus is not producing and making $0 profits, the
government in Europe might want to try to change the
equilibrium so that Airbus would earn positive profits.
 The government might want Airbus to produce.
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“Strategic” Use of High-Tech
Export Subsidies
• Multiple Equilibria
 The European government might decide to provide
subsidies to Airbus to achieve this.
 What happens to the payoff matrix, if anything, in such
a case?
 The type of subsidy we will consider is a cash payment
to Airbus.
 But in practice we know that subsidies can take on many forms.
 We will present a subsidy example in the “Headlines”
section next.
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Airbus, China and Quid Pro Quo
HEADLINES
• Airbus was negotiating to build an assembly line
for a new passenger plane in China.
• The deal would have a significant effect on its
business dealings there.
• Producing European planes in China would give
Airbus an advantage in the battle with Boeing for
the world’s next great aviation market.
• Airbus has 344 planes in service in China, Hong
Kong, and Macao, but Boeing still dominates with
nearly 2/3 of the market.
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Airbus, China and Quid Pro Quo
HEADLINES
• Airbus’ move shows the lengths it is willing to go
to break into China’s market, despite being active
there since 1985 without success.
• Boeing has no plans to build a production line in
China, but has still won orders to supply many of
its 737s to Chinese carriers.
• Airbus could greatly aid Europe in cultivating
commercial ties with China.
• Chinese and French leaders celebrate visits to
each other with the signing of aircraft deals.
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“Strategic” Use of High-Tech
Export Subsidies
• Effect of a Subsidy to Airbus
 Suppose the European governments provide a subsidy
of $25 million to Airbus to produce.
 This increases Airbus’ profits by $25 million when it
produces.
 Figure 10.6 shows the new payoff matrix.
 Remember that under free trade the Nash equilibrium
existed when one firm produced and the other did not.
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“Strategic” Use of High-Tech
Export Subsidies
• Best Strategy for Airbus
 Let’s begin at the Nash Equilibrium where Boeing
produces and Airbus does not.
 After the subsidy, this is no longer a Nash equilibrium.
 If Boeing is producing then Airbus is now better off by
also producing because of the $25 million subsidy.
 With the subsidy it now earns $20 million even when
Boeing produces ($25 subsidy - $5 losses).
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“Strategic” Use of High-Tech
Export Subsidies
Figure 10.6
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“Strategic” Use of High-Tech
Export Subsidies
• Best Strategy for Boeing
 If Airbus is now producing, is Boeing still making the
best decision?
 When Airbus produces, Boeing loses $5 million when it
produces, but loses nothing when it does not produce.
 Boeing will therefore find it best to drop out of the
market and not produce.
 Once Boeing decides not to produce, Airbus’ decision
does not change.
 The payoff to Airbus, however, now increases from $20
to $125 million.
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“Strategic” Use of High-Tech
Export Subsidies
• Nash Equilibrium
 It is easy to check that this result - the lower-left
quadrant is a Nash equilibrium.
 Each firm is making its best decision, given the action of the
other.
 It is also the only Nash equilibrium in this game.
 The effect of the government subsidy has been to shift
the equilibrium from having Boeing as the only
producer, to Airbus as the only producer.
 This is the only equilibrium possible now.
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“Strategic” Use of High-Tech
Export Subsidies
• European Welfare
 The subsidy has a big impact on the equilibrium of the
game, but is Europe better off?
 We can add up the welfare of various parties involved.
 Since Europe is producing for the rest of the world,
there is no consumer surplus in Europe.
 Airbus’ profits have increased from $0 to $125 million.
 The revenue cost of the subsidy is $25 million.
 The net gain in European welfare is +$100 million.
 The increase in profits are greater than the cost of the subsidy.
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Subsidy with Cost Advantage for Boeing
• What about cost differences?
 Let us now consider another case in which Boeing has
a cost advantage over Airbus.
 Assume the advantage is not from a subsidy, but due to
U.S. comparative advantage in aircraft production.
 This gives another payoff matrix in figure 10.7.
 Boeing earns profits of $5 million when both firms
produce, and profits of $125 million when Airbus does
not produce.
 The only Nash equilibrium—the upper right quadrant—
is where Boeing produces and Airbus does not.
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Subsidy with Cost Advantage for Boeing
Figure 10.7
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Subsidy with Cost Advantage for Boeing
• Can we have both?
 Now suppose the European government provides the
$25 million subsidy to Airbus but Boeing still has the
cost advantage.
 Best Strategy for Airbus
 With the subsidy in place, and Boeing producing, the best
decision for Airbus is to produce and earn profits of $20 million.
 Best Strategy for Boeing
 Given that Airbus produces, Boeing earns profits of $5 million
when it produces and $0 when it does not.
 Therefore, Boeing will stay in the market. Both firms
producing is now the new Nash equilibrium.
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Subsidy with Cost Advantage for Boeing
Figure 10.8
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Subsidy with Cost Advantage for Boeing
• European Welfare Once Again
 When Boeing has the cost advantage, the European
subsidy allows Airbus to enter the market.
 This has not resulted in the exit of Boeing as it did in
the earlier no-cost-advantage scenario.
 Airbus’ profits have increased from $0 to $20 million.
 The revenue cost of the subsidy to Europe is still $25
million.
 The net gain in European welfare is now -$5 million.
 When Boeing has the cost advantage, the subsidy
leads to a net loss in European welfare.
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Subsidy with Cost Advantage for Boeing
• Summary
 Under conditions of imperfect competition, a subsidy by
one government to its exporting firm might increase
welfare for its nation or it might not.
 There is an increase in welfare only if profits rise by
more than the cost of the subsidy.
 This is more likely satisfied if the subsidy leads to the
exit of the other firm.
 However, if both firms remain in the market, it is unlikely
that the increase in profits for the subsidized firm will
exceed the subsidy cost.
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Subsidies to Commercial Aircraft
APPLICATION
•
In the large passenger aircraft market, there are
now two large firms.
 Boeing in the U.S. (who merged with McDonnellDouglas in 1997)
 Airbus in Europe.
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Subsidies to Commercial Aircraft
APPLICATION
•
The U.S. and Europe have used various types of
subsidies to support their respective firms:
1. Indirect subsidies that arise because the R&D for
military versions effectively subsidize R&D for civilian
aircraft.
2. The government might directly subsidize the R&D
costs of a new aircraft, as Europe subsidizes R&D at
Airbus.
3. The government can subsidize the interest rates that
aircraft buyers pay when they borrow money to
purchase aircrafts.

Europe and the U.S. both provide low interest loans to aircraft
purchasers.
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Subsidies to Commercial Aircraft
APPLICATION
• 1992 Agreement
 Realizing the subsidies are costly, the U.S. and Europe
reached an agreement in 1992 to limit them.
 The main feature of the agreement is in Table 10.2.
 Development subsidies are now limited to 33% of the
total development costs of a new aircraft.
 It is expected that these subsidies will be paid back at
the government interest rate.
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Subsidies to Commercial Aircraft
APPLICATION
• 1992 Agreement:
 Limits indirect (military) subsidies to not more than 4% of any firm’s
annual sales.
 Prohibits production subsidies.
 Limits the ability of government agencies to subsidize the interest
rate on purchases of aircrafts.
• Reducing subsidies led to a rise in prices for aircraft by
3.1% and 8.8%.
• Governments benefited from no longer paying the
subsidy.
• Higher prices helped the firms, but led to welfare losses
for purchasing countries.
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Subsidies to Commercial Aircraft
APPLICATION
• Major Provisions of the 1992 Agreement







Aircraft Covered
Direct Support Levels
Interest Rates
Indirect Supports
Escape Clause on Emergency Aid
Production Supports
Dispute Settlement Mechanisms
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Subsidies to Commercial Aircraft
APPLICATION
• The Super Jumbo
 There are claims that the terms of the agreement are
being violated by Airbus.
 It is selling a new aircraft, the double-decker A380,
which is larger than the Boeing 747 and competes
directly with it.
 The expenditures to develop the A380 are estimated at
$12 billion.
 The European governments provided about $3.5 billion
in low-interest loans to cover development costs.
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Subsidies to Commercial Aircraft
APPLICATION
• The Super Jumbo
 In 2005, both the U.S. and the EU filed countercomplaints at the WTO regarding illegal subsidies by
the other party to their respective aircraft producers.
 Europe was accused of “illegally” subsidizing the A380,
while the U.S. was accused of subsidizing the
development of Boeing’s 787 commercial jet.
 The complaints charged that these subsidies violate the
1992 agreement.
 The U.S. is calling for termination of the agreement.
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Subsidies to Commercial Aircraft
APPLICATION
• National Welfare
 Will the subsidies to Airbus increase national welfare?
 From the previous information, it is more likely to
happen if Airbus is the only firm producing in that
market.
 Boeing has announced it will not produce a doubledecker like the A380.
 It will instead modify its current 747 and focus R&D on
its new 787 “Dreamliner” aircraft.
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Subsidies to Commercial Aircraft
APPLICATION
• National Welfare
 Since Boeing will not enter the double-decker market, it
is possible the profits earned by Airbus will cover the
subsidy.
 Of course that assumes the Boeing plane is not more of a direct
competitor to the Airbus.
 The profits earned will depend on how many are sold
and at what price.
 Airbus says it needs to produce at least 250 planes to
cover development costs, but expects to sell 1,500 over
the next 20 years.
 As of April 2006, it has orders for only 159 and many of
those has been discounted at least 10%.
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Subsidies to Commercial Aircraft
APPLICATION
• National Welfare
 In mid-June 2006, Airbus told its buyers it could not
deliver as promised—delays of 6 months or more.
 Several of the largest customers entered into
discussions to seek compensations for the delay.
 Singapore Airlines announced it would order the Boeing
787 “Dreamliner” instead.
 The stock price of Airbus’ parent company, EADS, fell
by more than one-quarter of its value in a single day.
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Subsidies to Commercial Aircraft
APPLICATION
• These events do not mean the Airbus A380 will
fail; delays happen often in this industry.
• These events do, however, illustrate the intensity
of the competition in the airline industry.
• This competition benefits consumers who will be
traveling on the new aircraft.
• However, competition makes it more difficult for
government subsidies to be recovered in profits
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Airbus in a spin as investors punish delays
HEADLINES
• Due to the production delays, Airbus’ parent
company, EADS, lost value on the market.
• Recently Airbus has struggled with many
problems on the production of their A380.
• Boeing on the other hand has been successful in
orders on its new 787 “Dreamliner” ramping up
the competition for Airbus.
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Airbus in a spin as investors punish delays
HEADLINES
• Problems in new aircraft development is not
unique to Airbus.
• In 1990, Boeing had to shut down assembly lines
and lost an assembly system due to issues with
keeping suppliers and deliveries on time.
• It also appears that Boeing may be having early
problems and delays in development of the 787,
but still claims they will have on time deliveries.
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Airbus in a spin as investors punish delays
HEADLINES
• Last year the industry had a significant number of
orders, higher than the previous industry peak.
• EADS’ profits rose 17% in 2005 and were
forecasted to rise 19% in 2006.
• It was stated that delays from the A380 would not
show in profit forecasts until 2007.
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Conclusion
• Countries use export subsidies in a wide range of
industries, including agriculture and hightechnology.
• In agriculture, there is an underlying motivation for
the subsidies to raise food prices and therefore
incomes to farmers.
• We found that export subsidies raise prices for
producers, increasing their real income and their
producer surplus.
• This costs consumers due to higher food prices in
the exporting country.
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Conclusion
• We obtained the net loss due to the subsidy for
the exporting country, which is a deadweight loss
similar to a tariff in a small country.
• For a large country, an import tariff and an export
subsidy have different welfare implications.
• Both export subsidies and import tariffs lead to a
rise in domestic prices and a fall in world prices.
• The fall in world prices from an export subsidy is a
terms-of-trade loss for the exporting country.
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Conclusion
• Applying an export subsidy in a large exporting
country leads to even greater losses than
applying it to a small country.
 There is no possibility of gain, as we found for a largecountry import tariff.
• The losses due to an export subsidy, for either a
small or large country, are less severe when we
instead consider production subsidies.
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Conclusion
• A production subsidy provides a farmer with an
extra payment for every unit produced, regardless
of whether it is sold at home or abroad.
• Consumer prices do not change from their world
level and exports increase only because domestic
supply increases.
• The excess supply due to the subsidies will
indirectly spillover into international markets.
• Losses due to production subsidies in an
exporting country are less severe than the losses
due to export subsidies.
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Conclusion
• At the Hong Kong meetings of the WTO, countries
agreed to eliminate export subsidies in agriculture
by 2013.
• The losses experienced by an export country due
to subsidies potentially changes when we
consider high-technology industries.
• We showed that it is possible for an export
subsidy to lead to gains for the exporting country,
if increased profits outweigh the cost of the
subsidy.
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Conclusion
• This, however, usually requires forcing the other
firm out of business, which does not always occur.
• If both firms do stay in the market, and are both
subsidized, it is unlikely that the subsidies are in
the national interest of the countries
• The countries that buy the goods, however, gain
from lower prices.
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Key Points
1. An export subsidy leads to a fall in welfare for a
small exporting country, similar to losses due to
import tariffs.
2. In the large country case, an export subsidy
lowers the price of that product in the rest of the
world.
3. Export subsidies applied by a large country
create a benefit for importing countries in the
rest of the world, by lowering their import prices.
4. Production subsidies to domestic producers also
have the effect of increasing domestic
production.
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Key Points
5. It is common for countries to provide subsidies to
their high-technology industries because
governments believe that these subsidies can
create a strategic advantage to their firms in
international markets.
6. A Nash equilibrium is a situation where each
player in a game is making their best response
to the action of the other player.
7. Export subsidies can affect the Nash equilibrium
of a game by altering the profits of the firms.
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