Subsidy Analysis

Question 1

What is a domestic subsidy?

Answer 1

This is a method of lowering domestic costs and prices, by the government paying subsidies to domestic producers (per unit of output), thus increasing the international competitiveness of their output both at home and in international markets.

Question 2

Draw a domestic subsidy diagram

Answer 2

Question 3

Summary of welfare effects of a domestic subsidy

Answer 3

• In an open economy scenario, consumers will be unaffected by the subsidy as our small change in production will not influence the world price for that product.
• Producers will gain as effectively the subsidy will reduce their costs of production, making them more internationally competitive and this allows them to produce more than before.
• Exporting countries will be worse off.
• The funding of the subsidy will come from government revenue and thus in a sense, the taxpayers are losing out.
• In contrast to a tariff, which generates revenue for the government, it instead has to pay out for the subsidies – opportunity cost of redirecting government funds away from elsewhere.
• In this scenario, the deadweight loss comes from the global misallocation of resources as inefficient producers are now producing goods, when we could alternatively be importing it at a lower cost.

Question 4

Which is less inefficient a production subsidy or an import tariff?

Answer 4

A production subsidy is less inefficient than import tariff, because the welfare loss is larger with an import tariff (in a small country case) …(b+d)>b… . It is also worthwhile to note that production subsidy causes smaller decrease in imports …by amount (q3-q1)… in comparison with the equivalent duty …by amount (q3-q1)+(q2-q4)… .