Question

Suppose Home is a small exporter of wheat. At the world price of $100 per ton, Home growers export 20 tons. Now suppose the Home government decides to support its domestic producer with an export subsidy of $40 per ton. Use the figure below to answer the following questions.

Home price се 140 100 Quantity 10 20 40 50

(a) What is the quantity exported under free trade with the export subsidy? How does this effect the figure?
(b) Calculate the effect of the export subsidy on consumer surplus, producer surplus and government revenue.
(c) Calculate the overall effect of the export subsidy on Home welfare.

Answer 1

(a)

With subsidy, price rises from $100 to $140. At this price, using the figure,

Domestic demand (QD) = 10

Domestic supply (QS) = 50

Exports = QS - QD = 50 - 10 = 40

(b)

(i) Consumer surplus (CS) = Area between demand curve and price

Since price rises after subsidy, CS will decrease.

Decrease in CS = (1/2) x Subsidy x (QD before subsidy + QD after subsidy) = (1/2) x $40 x (10 + 20) = $20 x 30 = $600

(ii) Producer surplus (PS) = Area between supply curve and price

Since price rises after subsidy, PS will increase.

Increase in PS = (1/2) x Subsidy x (QS before subsidy + QS after subsidy) = (1/2) x $40 x (40 + 50) = $20 x 90 = $1800

(iii) The subsidy will lead to a decrease in government revenue, imposing a cost to government.

Subsidy cost to government = Subsidy x Exports after subsidy = $40 x 40 = $1600

(c)

Effect of subsidy is a net welfare loss (deadweight loss = DWL).

DWL = Decrease in CS + Cost to government - Increase in PS = $(600 + 1600 - 1800) = $400