1b.

Using real world examples and taking into consideration the welfare losses of trade protection
measure, discuss whether production subsidies or tariffs are preferable from society’s point of view.
[15]

Introduction

A subsidy is a payment by the government to a firm for each unit of output produced. There
are two kinds of subsidies: production subsidy which is aimed at protecting domestic firms
from competing imports and export subsidy that is intended to protect firms that export.
We will illustrate with production subsidy. Tariffs are taxes on imported goods

Body: Explain effects on stakeholders

Tariffs
Tariffs are taxes on imported goods and it has
two objectives viz., to protect a domestic
industry from foreign competition and to help
raise revenue for the government.
 Initial position under free trade – country
accepts world price Pw; produces quantity Q1
and demands quantity Q4; imports Q4-Q1
 Suppose a tariff is imposed on imports; the
world supply curve shifts upwards with price
rising from Pw to Pw+t in the country
assuming that the country is a price taker.
 At Pw+t, domestic quantity supplied of
inefficient US producers increases from Q1 to
Q2. Domestic quantity demanded falls from
Q4 to Q3. Quantity of imports falls to Q2Q3
from Q1Q4. This happened in the US when the
country imposed a 20% tariff on EU
automobile imports in 2018, which affected
many stakeholders in the US and EU.
Figure 1: Tariff
Production Subsidy (need to compare effects
with those of tariff)
Production subsidy is aimed at protecting
domestic firms from competing imports.
Assume country accepts world price Pw and
produces quantity Q1 and demands quantity
Q2 with imports of Q2-Q1 (Figure 2).
 Suppose a production subsidy is granted
by the government to domestic firms to
make them more competitive. This will
effectively shift the domestic supply curve
downwards by the amount of the subsidy
to Ss.
 The goods continue to sell at the world
price Pw. But, after the subsidy, domestic
quantity supplied increases from Q1 to Q3.
As a result, the quantity of imports falls
from Q2-Q1 to Q3-Q1. For example, China
government has been accused of giving
production subsidy to domestic firms in
industries such as the solar panel, electric
battery and shipbuilding. This will have
consequences on the different
stakeholders.

Effects on different stakeholders

Figure 2: Production Subsidy

 Effects on different stakeholders
 Unlike tariffs, domestic consumers who
 Inefficient US domestic producers receive
higher price (Pw+t) and sell larger quantity of
Q2 instead of Q1. So, they are better off with
producer surplus rising from area g to g+c.
 Government receives revenue as shown by
the area e in Figure 1.
 However, US domestic consumers were worse
off as they pay a higher price (Pw+t) and buy  Given that a production subsidy is a trade
smaller quantity of Q3 instead of Q4. So, they
are worse off. This is also indicated by falling
consumer surplus from off as indicated by a
fall in the consumer surplus from areas abcdef
to ab (Figure 1).
 Foreign producers like EU automobile
producers such as BMW and Volkswagen who
have a comparative advantage or lower
opportunity cost in the production of cars are
worst off as their imports in the US market fell
from Q4-Q1 to Q3-Q2 (Figure 1) translating
into lower export revenues thus decreasing
employment in the important car industry in
Europe.
 A global misallocation of resources results.
The decrease in consumption and the shift of
production away from efficient foreign
producers and towards more inefficient
domestic producers translate into a
misallocation of resources both domestically
and globally. Hence there is a welfare or
deadweight loss equal to the area d+f (Figure
1).
 Moreover, tariff is a regressive tax which
burdens people on lower incomes
proportionately more than people on higher
incomes. This is because as income increases,
the proportion of income paid as taxes falls.
Hence the lower income consumes are
disproportionately worse off.
 Trade protectionism also provokes trade
retaliation. In response to the US tariffs on
buys electric batteries in China are not
affected. They continue to pay Pw.
Although they buy more of the domestic
good whose production has increased and
less of the imported good, the total
amount consumed remains unchanged at
Q2 units of output after the subsidy.
protection measure like a tariff, domestic
producers receive higher price (Pw+s) and
sell larger quantity of Q3 instead of Q1. So,
they are better off. This is indicated by a
producer surplus gain of area a (Figure 2).
 Unlike a tariff, the Chinese government
is negatively impacted as they must
spend tax revenues on the subsidy
which is equal to (Pw+s-Pw) X Q3 (or the
amount produced domestically).
Budget deficit deteriorates. There is an
opportunity cost to taxpayers as the
amount spend on the subsidy could
have been used elsewhere that would
benefit taxpayers. This includes
spending on merit goods such as
education, healthcare, manpower
training etc.
 Foreign producers from the US, for
example, are worse off as their imports
in China fell from Q2-Q1 to Q2-Q3. The
production subsidy lowers export
revenue of the more efficient foreign
producers with negative effects on
employment in the country. The effects
are similar to that of tariff. Hence, it will
also provoke a trade war as in the case
of China’s production subsidies which
led to tariff retaliation by the US.
 The subsidy is also similar to the tariff in
terms of misallocation of resources as it
shifts production away from efficient
 imports from Europe on a wide range of goods
including automobiles, aircrafts and wine, the
EU responded with retaliatory tariffs on US
imports such as spirits, Boeing aircraft US and
Salmon. The trade war erupted that between
US and many of its trading partners including
Europe and Japan led to falling exports in
these countries, hence slower economic
growths.
foreign producers and towards more
inefficient domestic producers. Hence,
resources are not allocated efficiently
both domestically and globally. Hence
there is a welfare or deadweight loss
equal to the area b in Figure 1 as the
gain in producer surplus is more than
offset by government expenditure on
the production subsidy for inefficient
domestic producers.

Evaluation

While both production subsidies and tariffs protect domestic producers and their workers from
foreign competition, the economic cost is high from a welfare point of view as they shift
production away from efficient foreign producers and towards more inefficient domestic
producers leading to global misallocation of resources. However, given that production subsidies
do not affect consumer surplus, which remains the same, welfare losses may therefore be smaller
compared with a tariff. Hence, of the two, subsidies could be preferred to tariffs. In the final
analysis, however, they both incur a substantial cost on society benefiting only the inefficient
domestic producers at a cost to foreign producers, consumers (tariff) and government (production
society) which increases if they provoke a trade war which is likely as demonstrated empirically
between US and its trading partners.