Ch. 6: Export Subsidies in Agriculture and High-Technology Industries

Unit 5 (Feenstra and Taylor, Chapter 10) completes the analysis of trade policy under perfect competition with the export side, and then turns to imperfect competition in high-technology industries. It covers five topics: (1) WTO goals on agricultural export subsidies; (2) export subsidies in a small home country; (3) export subsidies in a large home country; (4) production subsidies; and (5) high-technology export subsidies, analysed with game theory (Boeing versus Airbus).

What is an export subsidy?

An export subsidy is a payment to firms for every unit exported, either a fixed amount per unit (a specific subsidy) or a fraction of the sales price (an ad valorem subsidy). Governments grant subsidies to encourage domestic firms to produce and export more in particular industries, mostly in agriculture and in some industrial sectors. Europe maintains a system of agricultural subsidies known as the Common Agricultural Policy (CAP). Other countries are similarly generous: the United States pays cotton farmers to grow more cotton and subsidises agribusiness and manufacturers to buy American cotton.

WTO goals on agricultural export subsidies: the Hong Kong meeting (December 2005)

• Indirect subsidies: the agreement also eliminates indirect subsidies to agriculture in parallel with direct export subsidies.
• Domestic farm supports: any assistance to farmers, even if not tied directly to exports.
• Cotton subsidies received special attention because cotton is exported by many low-income African countries and is heavily subsidised in the United States.
• Tariffs in agriculture: export subsidies by large countries depress world prices, so exporting countries can expect tariffs to be imposed on the subsidised products when they are imported by other countries.
• Developing countries were split over farm protection: they may declare products special to shield them from full tariff cuts for food security, livelihood security or rural development. There was speculation that China would declare rice, cotton and sugar special products, which would hurt rice exporters such as Thailand and cotton exporters from West Africa.

Export subsidy in a small home country

Home is an exporter: the world price P W is above its no-trade price, so Home supply S 1 exceeds Home demand D 1 and Home exports X 1 = S 1 minus D 1. Home is small, so the world price is fixed.

1. A subsidy of s dollars per unit exported raises the price Home exporters receive from P W to P W + s.
2. Because firms can earn P W + s by exporting, they will only sell at home for the same price, so the domestic price also rises by s. (Home consumers cannot import the good at P W to avoid this, as the analysis assumes.)
3. Home quantity supplied rises from S 1 to S 2 and quantity demanded falls from D 1 to D 2, so exports rise from X 1 to X 2 (panel b).
4. The Home export supply curve shifts down by exactly the amount of the subsidy, since the marginal cost of a unit of exports falls by exactly s.

As with a tariff, the deadweight loss is the triangle (b + d): b is the consumption loss (consumers who buy less at the higher price) and d is the production loss (units produced at a marginal cost above the world price). A small exporting country therefore always loses from an export subsidy.

Worked example. Home demand D = 100 minus 10P, Home supply S = 10P minus 20. No-trade price: 100 minus 10P = 10P minus 20, so P = 6. The world price is P W = 8: D 1 = 20, S 1 = 60, exports X 1 = 40. A subsidy s = 1 raises the domestic price to 9: D 2 = 10, S 2 = 70, X 2 = 60.

Export subsidy in a large home country

If Home is a large exporter, the subsidy also changes the world price. In the world market, the subsidy shifts the Home export supply curve out (down) from X to X minus s, reflecting the lower marginal cost of exports. With a downward sloping Foreign import demand curve, the world price falls from P W to P*. Home exporters receive P* + s, so the Home price rises from P W to P* + s, which is less than P W + s. Home demand falls from D 1 to D 2 and supply rises from S 1 to S 2.

This is the opposite of a tariff: a large country's import tariff gives it a terms-of-trade gain, whereas a large country's export subsidy gives it a terms-of-trade loss, because it lowers the world price of the good it sells. Welfare of the exporter falls because of both the deadweight loss and the terms-of-trade loss.

Worked example. Keep Home demand D = 100 minus 10P and supply S = 10P minus 20, so Home export supply is X = S minus D = 20P minus 120. Foreign import demand is M* = 120 minus 10P. Free trade: 20P minus 120 = 120 minus 10P gives P W = 8 and exports 40. A subsidy s = 1.5: exporters receive P* + 1.5, so 20(P* + 1.5) minus 120 = 120 minus 10P*, which gives P* = 7; the Home price is 8.5 and exports rise to 50 (Home D = 15, S = 65).

The world price fell by 1 and the Home price rose by only 0.5, so two thirds of the subsidy (1 out of 1.5) is passed on to foreign buyers. This is also why a large country's export subsidy of 10 euros can raise the domestic price by only part of the subsidy, for example 5 euros (mock exam question).

Who gains and who loses when agricultural export subsidies are eliminated?

Gains: agricultural exporting countries gain from the rise in world agricultural prices as subsidies (especially in industrial countries, the EU and the United States) are removed. Losses: food-importing countries, typically poorer countries that do not produce enough food, lose because they pay higher prices. Several empirical studies confirm this theoretical result: many of the poorest countries are net food importers and will face higher prices when EU and US agricultural subsidies are removed. The subsidising countries themselves gain, because they save the deadweight loss and the terms-of-trade loss.

Production subsidies

A production subsidy pays s dollars for every unit a Home firm produces (for example every ton of sugar), not just for the units exported. Governments can implement it by guaranteeing farmers a minimum price and paying the difference when the market price is lower, or by subsidising users of the crop to buy it, which raises demand and market prices and acts as a subsidy to every unit produced.

Small country. Producers receive P W + s, so Home supply rises from S 1 to S 2. The consumer price is not affected, because the subsidy does not distinguish between units sold at home and abroad; firms continue to charge the world price at home, so demand stays at D 1. Exports rise from X 1 to X 2, but by less than under an export subsidy of the same size because home demand does not fall.

In the worked example (D = 100 minus 10P, S = 10P minus 20, P W = 8), a production subsidy of 1 raises the producer price to 9 and supply to 70 while demand stays 20, so exports rise to 50 (instead of 60 with the export subsidy). PS rises by 65, the subsidy costs 1 × 70 = 70, and the net loss is 5, only the production triangle, compared with 10 for the export subsidy.

Large country. With a production subsidy, exports rise only because Home supply increases, so the Home export supply curve shifts down by less than s (with an export subsidy it shifts down by exactly s, because both the supply increase and the demand decrease add to exports). With a downward sloping Foreign import demand curve, the production subsidy would lower the world price, but by less than an export subsidy. Hence the deadweight loss and the terms-of-trade loss of a production subsidy are both smaller.

High-technology export subsidies

Governments subsidise high-technology industries because they may create benefits that spill over to other firms in the economy: they are believed to produce a positive externality. This argument resembles the infant industry argument for tariffs. In addition, governments and industries argue that export subsidies can give a strategic advantage to export firms competing with a small number of rivals in international markets.

To analyse strategic use of subsidies, the model assumes imperfect competition with two firms, a duopoly, and uses game theory: the modelling of strategic interactions (games) between firms as they choose actions that maximise their returns.

The Boeing and Airbus game

Each firm must decide whether to produce a new type of aircraft. The payoff matrix (profits in millions of dollars; first number Boeing, second Airbus):

• If Airbus produces, Boeing is better off not producing (0 > minus 5), and vice versa. So both producing is not a Nash equilibrium: the market is only profitable for one firm.
• Airbus producing and Boeing not producing is a Nash equilibrium: each makes its best decision given the other's action. By the same reasoning, Boeing producing and Airbus not producing is also a Nash equilibrium.
• With multiple equilibria, some force outside the model determines which one occurs, for example a first-mover advantage: the firm that decides first to produce captures the market.

Subsidy to Airbus. The European governments give Airbus a subsidy of $25 million if it produces. Airbus's payoffs rise by 25 whenever it produces:

Now Airbus earns $20 million by producing even when Boeing produces, instead of losing $5 million, so producing is always best for Airbus. Boeing, knowing this, drops out. The unique Nash equilibrium is Airbus produces, Boeing does not. European welfare: rise in producer profits +125 (from 0 to 125), fall in government revenue minus 25, net +100. Here the subsidy is worthwhile because it raises profits by more than it costs, by inducing the rival to exit.

Subsidy with a cost advantage for Boeing. Suppose Boeing has lower costs: it earns $5 million when both produce and $125 million alone, while Airbus earns minus 5 when both produce and 100 alone.

Producing is always best for Boeing (5 > 0 and 125 > 0), and Airbus's best response is not to produce: the unique Nash equilibrium is Boeing produces, Airbus does not. With the $25 million subsidy, Airbus earns 20 when both produce, so both produce becomes the unique Nash equilibrium (Boeing still earns 5 > 0). Airbus profits rise from 0 to 20 but the subsidy costs 25: European welfare falls by 5. The subsidy does not drive Boeing out, so it is not worthwhile.

Subsidies to commercial aircraft in practice include indirect subsidies arising in the production of civilian and military aircraft, direct subsidies for R&D, and subsidised interest rates for buyers who borrow to purchase aircraft. If both firms stay in the market and both are subsidised, the subsidies are unlikely to be in the national interest of either the United States or the EU: the countries buying the aircraft gain from lower prices, while the subsidising countries bear the cost.

Applications. A preliminary WTO report found that Airbus received illegal subsidies (a complaint filed by the United States on behalf of Boeing, alleging billions of dollars of illegal subsidies from 1970 to 2004); Airbus might have to refinance its launch loans on commercial terms. Boeing, for its part, had its 787 Dreamliner partly financed by suppliers who bankrolled their own parts of the project after the September 11 attacks made Boeing reluctant to invest more than $10 billion; this spread costs and risks but led to quality problems and delays.

Key points

1. For a small exporting country, an export subsidy lowers welfare; the loss is a deadweight loss made up of a consumption and a production loss, as with a tariff in a small country.
2. For a large country, an export subsidy lowers the world price, a terms-of-trade loss; welfare falls through both the deadweight loss and the terms-of-trade loss, in contrast with a large country's tariff, which gives a terms-of-trade gain.
3. A large country's export subsidies benefit importing countries by lowering their import prices.
4. Removing such subsidies therefore hurts net food importers, which include many of the poorest countries.
5. Production subsidies also raise domestic production but leave consumers unaffected; their deadweight loss and terms-of-trade loss are smaller than for an equal export subsidy.
6. Subsidies to high-technology industries (with imperfect competition) can give domestic firms a strategic advantage.
7. Export subsidies can change the Nash equilibrium of a game by altering firms' profits.
8. If a subsidy raises a firm's profits by more than its cost, it is worthwhile for the government.
9. Subsidies are not worthwhile unless they induce the rival to exit, which may not happen.