8.3 Production Subsidies as a Reason for Trade

This section will show how a production subsidy can cause trade for a small, perfectly competitive, open economy. The analysis indicates that domestic policies can be a cause of trade even in the absence of other reasons for trade. In other words, even if countries were identical with respect to their resource endowments, their technology, and their preferences and even if there were no economies of scale or imperfectly competitive markets, domestic policies could induce trade between countries.

Consider a small open economy with a perfectly competitive industry. Let the domestic market be represented by the supply and demand curves in Figure 8.1 "Inducing Exports with a Domestic Production Subsidy". Suppose initially that free trade is allowed with the rest of the world, but by coincidence (actually by assumption), let the free trade price be exactly equal to the autarky price for the good. This is shown as the price, P_FT. This implies that no imports or exports occur, even though there is free trade.

Figure 8.1 Inducing Exports with a Domestic Production Subsidy

Next, suppose that the government of this country offers a specific (per unit) production subsidy to the domestic firms. Let the subsidy rate be set at “s.” This means the government will pay “s” dollars for every unit the domestic firm produces, regardless of where the product is sold.

The subsidy effectively raises the price that the producer receives for each unit of the good produced and sold. At the same time, the subsidy will not affect the domestic price that consumers pay. In other words, the subsidy will cause the price received by producers (the producer price) to rise above the price paid by consumers (the consumer price). The new producer price is labeled P_P in Figure 8.1 "Inducing Exports with a Domestic Production Subsidy", while the consumer price, P_C, remains equal to the free trade price. Thus P_P = P_FT + s and P_C = P_FT. These price changes occur because these prices will allow domestic firms in the small country to maximize their profits in the face of free competition with firms in the rest of the world.

The subsidy will increase domestic production. At the market price P_FT, domestic firms were willing to supply to Q₁. Once the producer price rises to P_P, domestic supply will rise to Q₂. Demand would remain the same, however, since the consumer price remains fixed. The difference between domestic supply and demand, Q₂ − Q₁, represents the level of exports to the rest of the world. Since exports did not exist prior to the subsidy, this is an example in which a domestic policy (a production subsidy) can cause trade (i.e., exports) to occur.