US and Canada are two large countries in a cotton market. Assume that demand and supply curves are linear in both countries. With free trade the US exports 50 bales of cotton to Canada at a price of $400/bale. Under pressure from cotton farmers, US introduces an export subsidy of $80/bale. As a result, exports rise by 20 bales and the world price of cotton falls to $360/bale.

1. What impact does the export subsidy have on the price of cotton in the U.S. market? 
2. What is the cost of the export subsidy to the U.S. government?
3. What is the total deadweight loss caused by the subsidy in the US?
4. How large is the overall gain or loss for the US economy from the subsidy?
5. How large is the overall gain or loss for Canada? 
6. How large is the gain or loss for the world?

 

U.S. government subsidies effectively reduce the net price paid by buyers of U.S. cotton and thus increase the demand for U.S. upland cotton. This increases demand and in turn, stimulates increased production. When a large exporting country like U.S implements an export subsidy, it will cause an increase in the price of the good on the domestic market and a decrease in the price in the rest of the world.

Step-by-step explanation

An export subsidy will raise the domestic price and, in the case of a large country like U.S, it reduces the foreign price. An export subsidy will increase the quantity of exports with the export subsidy in place in a two-country model, export supply at the higher domestic price will equal import demand at the lower foreign price.

Export subsidy affects the importing country's consumers. Consumers of the product in the importing country like Canada experience an increase in well-being as a result of the export subsidy. The decrease in the price of both imported goods and the domestic substitutes increases the amount of consumer surplus in the market.

Producers in the exporting country (U.S) experience an increase in well-being as a result of export subsidy. The increase in the price of their product in their own market raises producer surplus in the industry. The price increase also induces an increase in output, an increase in employment, and an increase in profit, payments, or both to fixed costs.

The net effect consists of three components: a negative terms of trade effect, a negative consumption distortion, and a negative production distortion. Thus the export subsidy must result in a reduction in national welfare for the exporting country.

Consumers of the product in the importing country like Canada experience an increase in well-being as a result of the export subsidy. The decrease in the price of both imported goods and the domestic substitutes increases the amount of consumer surplus in the market.

Producers in the importing country (Canada) suffer a decrease in well-being as a result of the export subsidy.

National welfare falls when a large country implements an export subsidy. For instance here the U.S is exporting the cotton to Canada at a subsidized price.

National welfare in the importing country rises (Canada) when a large exporting country (U.S) implements an export subsidy.

An export subsidy of any size will reduce world production and consumption efficiency and thus cause world welfare to fall. Thus it is a loss.