Question

QUESTIONS Q1) Explain the differences and similarities between the welfare implicantions of a tariff and a production subsidy with the help of a diagram. Specify your assumptions.

Answer 1

A tariff is a typical policy that is aimed to protect a particular industry from foreign imports. It comes under mounting pressure in the regime of the General Agreement on Tariffs and Trade (GATT) and the World Trade Organization (WTO).

An alternative policy of industry protection is a production subsidy. The production subsidy provides a payment based on all production regardless of where it is sold. For example, Korea implemented an agriculture compensation system when it concluded an Free Trade Area with the US. Production subsidies to agricultural sectors in the US and the European Union (EU) amount to around 20 and 70 billion dollars per year, respectively. Noting the expanding importance of such policy changes, we analyze the welfare effect of a replacement of a protective tariff by a production subsidy with a commodity tax. It is well known that a tariff attains higher welfare than a production subsidy when the country has monopoly power in trade (Bhagwati, 1971). However, if a certain degree of industry protection is required, the superiority of a tariff over a production subsidy may be ambiguous.

We begin by demonstrating the effects of a consumption tax and a production subsidy applied simultaneously by a small importing country. Then, we will show why the net effects are identical to an import tariff applied in the same setting and at the same rate.

Page No.: Date : PFT S, জप् Static weeforu effacts of Puoduction Subsidy + Congumption Ton Impounting Conuntny - (a+b+c+d) Consumer Surplus Producer Surplus +(atbt c) (atb) Revenue Tare Cost Subridy Governmint Revenue -(btd) National Welfae Scanned with. CamScanner

We depict the initial equilibrium in the adjoining diagram. The free trade price is given by P_FT. The domestic supply is S₁ and domestic demand is D₁ which determines imports in free trade as D₁ - S₁.

When a specific consumption tax "t" the consumer price increases by the amount of the tax to P_C. Because free trade is maintained, the producer's price would remain at P_FT,. The increase in the consumer price reduces domestic demand to D₂.

When a specific production subsidy "s" is implemented the producer price will rise by the amount of the tax to P_P, but it will not affect the consumption price. As long as the production subsidy and the consumption tax are set at the same value (i.e., t = s), which we will assume, the new producer price will equal the new consumer price. (i.e., P_C = P_P).

The effect of the production subsidy and the consumption tax together is to lower imports from D₁ - S₁ to D₂ - S₂.

Consumers suffer a loss in surplus because the price they pay rises by the amount of the consumption tax.

Producers gain in terms of producer surplus. The production subsidy raises the price producers receive by the amount of the subsidy, which in turn stimulates an increase in output.

The government receives tax revenue from the consumption tax but must pay out money for the production subsidy. However, since the subsidy and tax rates are assumed identical and since consumption exceeds production (because the country is an importer of the product) the revenue inflow exceeds the outflow. Thus, the net effect is a gain in revenue for the government.

In the end, the cost to consumers exceeds the sum of the benefits accruing to producers and the government, thus, the net national welfare effect of the two policies is negative.

Notice that these effects are identical to the effects of a tariff applied by a small importing country if the tariff is set at the same rate as the production subsidy or the consumption tax. (See page 90-11 for a comparison). If a specific tariff "t", of the same size as the subsidy and tax, were applied, the domestic price would rise to P_P = P_FT + t. Domestic producers, who are not charged the tariff, would experience an increase in their price to P_P. The consumer price would also rise to P_P. This means that the producer and consumer welfare effects would be identical to the case of a production subsidy/consumption tax. The government would only collect a tax on the imported commodities, which implies tariff revenue given by (c). This is exactly equal to the net revenue collected by the government from the production subsidy and consumption tax combined. The net national welfare losses to the economy in both cases are represented by the sum of the production efficiency loss (b) and the consumption efficiency loss (d).