EXPORT SUBSIDIES IN AGRICULTURE AND HIGH-TECHNOLOGY INDUSTRIES 1 WTO Goals 2 Agricultural Export Subsidies in Small Country 3 Agricultural Export Subsidies

EXPORT SUBSIDIES IN AGRICULTURE AND HIGH-TECHNOLOGY

INDUSTRIES

1WTO Goals

2Agricultural Export

Subsidies in Small Country3

Agricultural Export Subsidies

in Large Country4

Agricultural Production Subsidies

5High-Tech Export

Subsidies6

Conclusions

10

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2 of 118

Introduction

• In December 2005, representatives of the 149 countries belonging to the WTO met in Hong Kong to discuss reforms of the world trading system.

• The main focus of these meetings was the trade policy (tariffs and subsidies) on agricultural products. Lower world prices hurt farmers in land-rich developing

countries like Brazil, India, and China. But lower world prices benefit land-poor developing

countries that import agricultural products.


Introduction

• The first goal of this chapter is to explain agricultural subsidy policies.

• The primary reason for agricultural export subsidies is political.

• Examine how export subsidies can be used strategically by governments to bolster domestic companies and industries E.g. high-tech industries

• Legislators often believe that subsidies to high-tech industries might raise their profits and benefit the exporting countries.


WTO Goals on Agricultural Export Subsidies

• Agricultural Export Subsidies An export subsidy is a payment to a firm for every unit

exported. A fixed amount or a fraction of the sales price.

Governments give subsidies to encourage domestic firms to increase production in particular industries.

Europe maintains a system of agricultural subsides known as the Common Agricultural Policy (CAP). As a result, the sugar beet subsidy makes Europe a leading

supplier of sugar, even though other countries have a natural comparative advantage over Europe.

Other countries maintain similarly generous subsidies. U.S. pays cotton farmers to grow more cotton and subsidizes

agribusiness and manufacturers to buy the American cotton.


WTO Goals on Agricultural Export Subsidies

• Domestic Farm Supports These include any assistance given to farmers, even if it is not

directly tied to exports. These programs can still have an indirect effect on exports by

lowering production costs, and therefore the competitiveness, of domestic products.

• Cotton Subsidies Export subsidies in cotton received special attention because that

crop is exported by many low-income African countries and is highly subsidized in the U.S.

Although the U.S. agreed to eliminate them, it still leaves open other domestic supports to cotton not directly tied to exports.

• Let’s look at the effects of export subsidies on a “small” country.


Agricultural Export Subsidies in a Small Home Country

World Price

Home Price

Quantity Exports

D SX

B

X1

Home export supply

Foreign import demand

A

S1D1 X1

PW

The free trade equilibrium at world price PW, gives exports of X1 and a horizontal Foreign import

demand. Equilibrium is at B.

Figure 10.1(without subsidy)



• Impact of an Export Subsidy Suppose the government wants to boost domestic

exports of sugar. Each ton of sugar exported receives a subsidy, s.

Exporters will receive PW+s for each ton exported. Domestic price must rise to PW+s, otherwise firms will

not sell any output domestically.

Home consumers could just import sugar at the world price, PW.

Therefore, Home will impose a tariff equal to or higher than the amount of the export subsidy. This typically happens and, is therefore, realistic.



• Impact of an Export Subsidy

The combined effect of the subsidy and the tariff is to raise the price at Home.

Exports increase due to two factors: Higher domestic price (movement along supply curve). Subsidy (shifts the export supply curve).

Production and Consumption effects.

As with a tariff, the subsidy has driven a wedge between what domestic exporters receive (PW+s), and what importers abroad pay (PW).



World Price

Home Price

Quantity Exports

D SX

B

A

S1D1 X1

PW

PW+sC

With the subsidy, the Home price rises to PW+sThis decreases demand to D2, increases supply to S2, and increases exports to X2. Equilibrium is at C.

X2

D2 X2S2

X–s

C'

s

s

The Home export supply curve shifts down by exactly the amount of the subsidy. MC of production falls by exactly s.

X1

Figure 10.1(with subsidy)



• Impact of the Subsidy on Home Welfare

The rise in price lowers consumer surplus by (a+b).

The rise in price raises producer surplus by (a+b+c).

The export subsidy costs the government the amount of the subsidy, s, times the amount of exports, X2 shown by (b+c+d).

Adding up this impact, we are left with a net effect on Home welfare of –(b+d). b is the production loss or efficiency loss for the economy. d is the consumer loss for the economy.



The increased price decreases consumer surplus by (a+b)

The subsidy costs the government the amount –(b+c+d)

World Price

Home Price

Quantity Exports

D SX

B

A

S1D1 X1

PW

PW+sC

D2 X2S2X2

X–s

C'

s

s

Producer surplus increases by (a+b+c)

a

b d

This leaves us with a deadweight loss of (b+d) as before.

c

Total deadweight loss, b+d

Figure 10.1(with welfare effects)


Agricultural Export Subsidies in a Large Home Country

• Now suppose Home is large enough that its subsidy affects the world price of sugar. Foreign export demand curve, M*, is downward sloping.

• Note that the new world price, P*, is less than PW although the new Home price is PW+s. Home terms of trade fall but foreign terms of trade rise.

• Since Home terms of trade fall, the Home country will suffer overall losses.

• Foreign consumers will gain.




Exports

Home exports supply, X

D

Home Price

Foreign import demand, M*

World Price

S

X–ss

P*

Quantity

s

P*+s

(a) Home Market (b) World Market

S1D1

PW

X1

X1

Home applies a subsidy, shifting the export supply curve right by the amount of the subsidy, s

S2D2 X2

X2

The new world price is at new equilibrium, P*. New Home price is P*+s

Home demand decreases and home supply increases leading to increased exports, X2

We begin in free trade equilibrium



• Home Welfare The higher Home price reduces consumer surplus by

(a+b).

Additionally, the higher price increases producer surplus by (a+b+c).

We also need to consider the cost of the subsidy—the amount of the subsidy times the exports after the subsidy, area (b+c+d+e).

This gives a net welfare loss of (b+d+e).

Area e represents the terms of trade loss.




S2

D

Home Price

Sd

es PW

P*+s

P*

c

S1D1D2 Quantity

a

b

Consumer surplus falls by -(a+b).

Producer surplus increases by +(a+b+c).

The subsidy costs the government -(b+c+d+e): subsidy times exports.

This leaves a net deadweight loss of (b+d+e), greater than in a small country.

Home Welfare



• Foreign and World Welfare

From Home’s perspective, the terms of trade loss is just (e), but when we move to foreign welfare next, it will be useful to break up (e) into the two parts e’ and f.

The price of Foreign imports decreases leading to an increase in Foreign consumer surplus by (e′).

Combining Home welfare loss of (b+d+e) and subtracting Foreign terms-of-trade gain (e′), there is an overall deadweight loss for the world, (b+d+f) in panel b.

The area (f) is the additional world deadweight loss due to the subsidy.



Figure 10.2(without subsidy)

ExportsS2

Home exports supply, X

D

Home Price

Foreign import demand, M*

X–s

World Price

Sd

e

s

s PW

P*+s

P*

c

X2X1S1D1D2 Quantity

a

b

e'

b+d

f


World Consumer surplus rises by -(e’) which is a terms of trade gain

f is an additional World loss due to decrease in Home’s terms of trade not completely offset by increases in World’s terms of trade

With Home welfare loss of (b+d+e) and Foreign terms-of-trade gain (e’), there is an overall deadweight loss for the world of (b+d+f) in panel b



• Foreign and World Welfare This transfer of terms of trade is what countries

sometimes use to make subsides sound like good ideas to “aid” poorer countries.

However, the deadweight loss (f) means using the export subsidy to increase exports is an inefficient way to transfer gains from trade among countries.

It would be more efficient to just give cash aid to the poorer countries. Cash does not change trade levels so would not have

deadweight loss of (b+d+f). This is why the European countries eliminated transfers of food

as a form of aid several years ago.

© 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor

APPLICATION

19 of 118

Who Gains and Who Loses?

• Let’s return to the Hong Kong meeting of the WTO in December 2005 to see which countries will gain and which will lose when the export subsidies are eliminated by 2013.

• Gains Obvious winners will be current agricultural exporters in

developing countries such as Brazil, Argentina, Indonesia, and Thailand, along with potential exporters such as India and China.

These countries will gain even more when and if an agreement is reached on eliminating agricultural tariffs in the industrial countries.


APPLICATION

20 of 118


• Gains These actions will also benefit industrial countries,

suffering from deadweight losses and terms-of-trade losses from the combination of subsidies and tariffs.

Clearly the farmers in industrial countries who lose the subsidies will be worse off. Given that it is usually the largest farmers who gain the most

from subsidy programs, they may be better able to adjust to the elimination of subsidies than smaller farmers.


APPLICATION

21 of 118


• Losses Given that eliminating subsidies will typically lead to

increased world prices, food-importing countries, typically the poorer non-food producing countries, will lose.

One study finds that the existing pattern of agricultural supports raises the per-capita income of two-thirds of 77 developing nations, including most of the poorest countries such as Burundi and Zambia.


APPLICATION

22 of 118


• Losses Figure 10.3 shows some of these results. Poor countries are net importers of essential food items

such as corn, rise, and wheat, and would be harmed by an increase in their world price.

Many of the world’s poorest individuals depend on cereal crops for much of their diet and would be especially hard hit by any increase in those prices.


APPLICATION

23 of 118


Figure 10.3


APPLICATION

24 of 118


Figure 10.3



• The agreements reached in Hong Kong distinguish between export subsidies in agriculture and all other forms of domestic support that increase production. Tax incentives and other types of subsidies

• This is because it is expected that these other forms have less impact on exports than do direct subsidies.

• In this section, therefore, we will examine the impact of a production subsidy in agriculture for both a small and a large country.



• A production subsidy is when the government provides a subsidy of s dollars for every unit that a Home firm produces. It is a subsidy to every unit produced, not just to units

exported.

• The subsidy can be implemented by the government: guaranteeing a minimum price to the farmer. providing subsidies to the users of the crop to purchase

it, thereby increasing demand for the crop and the price.



• These policies all fall under Article XVI of the GATT.

• This states that partner countries should be notified of the extent of such subsidies, and where possible, these subsidies should be limited.

• In Hong Kong, the WTO members further agreed to classify countries according to the extent of such subsidies.



• Effect of a Production Subsidy in a Small Home Country We have a small country with a fixed world price of PW. There is a subsidy of s increasing Home price to

producers to PW+s. Quantity demanded at home does not change since

producers still charge the world price at Home. This happens because Home producers receive the

subsidy no matter who they sell to. The production subsidy increases exports by less than

an export subsidy.


C'

X2

C

B


World Price

PW

S1

DS

X X’


Figure 10.4(with production subsidy)

s

PW+s

Home Price

D1 QuantityS2

S-s

X1 Exports

Subsidy increases price to producers increasing supply to S-s producing S2. Home quantity demanded does not change.

We can see in (b) that Home export supply increases, showing that exports increase from X1 to X2. This is a smaller increase than with an export subsidy since Home demand does not change.



• Home Welfare Producer surplus rises by (a+b) in panel a. Government cost of the subsidy is (a+b+c) – the

amount of subsidy s times total production S2. Consumer surplus is unaffected since quantity

demanded is unaffected. This leaves a new effect on Home welfare of (–c). The deadweight loss caused by the production subsidy,

(c), is less than that caused by the export subsidy, (b+d).

The only deadweight loss is in production inefficiency—producers produce at higher than marginal cost.


C

BC'


World Price

PW

S1 X2

DS

X X’

s


Figure 10.4(with welfare effects)

PW+s

Home Price

S2D1 Quantity

S-s

ac

b

X1 Exports

Home producer surplus rises by (a+b)Subsidy costs government (a+b+c)

Deadweight loss from production subsidy is c, which is less than with export subsidy of (b+d) in figure 10.1.



• Targeting Principle

Since the deadweight loss is lower for this subsidy than for the export subsidy, it makes a better policy instrument for the purpose of increasing Home supply.

This is an example of the targeting principle. To achieve some objective, it is best to use the policy

instrument that achieves the objective most directly.

To use an example from this book, it is better to provide trade adjustment assistance directly to those affected, than to impost a tariff or quota.



• Effect of Production Subsidy in a Large Home Country

We will not draw this case in detail but will use figure 10.4 to briefly explain.

Price rises from PW to PW+s, and Home production increases to S2.

Since demand has not changed, exports increase by the same amount as the change in Home supply.

The rise in exports from B to C′ is less than the increase in exports with an export subsidy, from B to C.


B


World Price

PW

S1

DS

X X’

C'

X2

C

s


Production Subsidy for a Large Home Country

PW+s

Home Price

S2D1 Quantity

S-s

X1 Exports

The production subsidy leads to increase in price to PW+s and increased production to S2 increasing exports by S1-S2

ΔX

We see this as an increase in the export supply curve from X to X’ changing the equilibrium from B to C’

This increase in exports (B to C′) is less than we saw with an export subsidy (B to C).



• Effect of Production Subsidy in a Large Home Country In the export supply subsidy, the increase in exports

occurred due to the increase in supply and the decrease in demand. The export supply curve shifted down by the exact amount of

the subsidy, s, (as in figure 10.1). With a production subsidy, the exports increased only due to

the increase in Home production. The export supply curve then shifted down by an amount less

than s, (as in figure 10.4).



• Effect of Production Subsidy in a Large Home Country If we draw a downward-sloping foreign import demand curve

in panel b, then the increase in supply due to the production subsidy would lower the world price.

But the drop in world price would be less than the drop that occurred with the export subsidy, since the increase in exports is less.

• Production subsidies in agriculture still lower world prices, but by less than export subsidies.

• Therefore, the WTO is less concerned about eliminating production subsidies and other forms of domestic support for agriculture.


High-Technology Export Subsidies

• We now change focus from agriculture to high-technology products.

• The high-tech sector also receives substantial subsides from the government. An example being subsidies to the aircraft industries in both the

U.S. and Europe.

• In the U.S., subsidies take the form of low-interest loans provided by the Export-Import Bank. The Export-Import Bank is a U.S. government agency that

finances export related projects.

• Japan and South Korea give direct subsidies to high-tech manufacturing firms and reach certain targets for export sales.



• One reason that some governments support high-tech industries is because of the possible spillover benefits to other areas of the economy.

• Governments believe there is a positive externality that exists from the production of high-tech products, so subsidizing them increases production and minimizes the externality.

• This is similar to the infant industry argument for tariffs, but is applied to an export instead of an import.



• “Strategic” Use of High-Tech Export Subsidies Governments argue subsidies might give a strategic

advantage to export firms competing with a small number of rivals in international markets. If extra profits are greater than the subsidy, then the exporting

country has an overall gain.

We will use an assumption of imperfect competition to examine this issue. duopoly

Each firm can set the price and quantity of its output based on the price and quantity decisions of the other firm.



• “Strategic” Use of High-Tech Export Subsidies We then examine the effects of strategic export

subsidies in determining whether the profits of the exporting firm will rise enough to offset the cost of the subsidy to the government.

To capture strategic decision making of two firms, we will use game theory. The modeling of strategic interactions (games) between

firms as they choose actions that will maximize their returns.

The goal is to model the strategic interactions of high-tech firms in Home and Foreign, and then see the impact of export subsidies on their respective decisions and payoffs.



• “Strategic” Use of High-Tech Export Subsidies We begin with free trade. Two firms are competing for sales of a new type of

aircraft. We will focus on the decision of each firm to develop

the new aircraft, that competes with the aircraft of the other firm for sales to the rest of the world.

We will ignore sales in their own countries, so we do not have to keep track of consumer surplus.

Welfare is only dependent on the profits earned by Boeing or Airbus from sales to the rest of the world.


“Strategic” Use of High-Tech Export Subsidies

• Payoff Matrix Figure 10.5 shows a payoff matrix for Boeing and

Airbus.

Each producer must decide whether or not to produce the new aircraft.

Each quadrant of the matrix shows the profit earned by Boeing in the lower-left corner.

The profits of Airbus are in the upper-right corner.



Figure 10.5



• Nash Equilibrium We want to determine the outcome of this game

between the two firms. We use the concept of the Nash Equilibrium.

The action of each player is the best possible response to the action of the other player.

• Best Strategy for Boeing What are Boeing’s possible strategies if Airbus chooses

to produce? Systematically work through the matrix. The bottom left square is a Nash Equilibrium.



• Multiple Equilibria Is it possible to have more than one Nash Equilibrium? What if Boeing decides to produce first. We can then look at the top row and see that Airbus’

best strategy is to not produce. If Airbus does not produce, looking at the last column of

the matrix, Boeing’s best strategy is to produce. Therefore, the top right-hand box, with Boeing

producing and Airbus not producing, is also a Nash Equilibrium.



• Multiple Equilibria

When there are two Nash equilibria, then there must be some force that determines which one we are in.

One of these is the first mover advantage. One firm is able to decide whether or not to produce before the

other firm.

Suppose we start at the Nash equilibrium in the upper-right quadrant. Because Airbus is not producing and making $0 profits, the

government in Europe might want to try to change the equilibrium so that Airbus would earn positive profits.

The government might want Airbus to produce.



• Multiple Equilibria The European government might decide to provide

subsidies to Airbus to achieve this. What happens to the payoff matrix, if anything, in such

a case? The type of subsidy we will consider is a cash payment

to Airbus. But in practice we know that subsidies can take on many forms.

We will present a subsidy example in the “Headlines” section next.


HEADLINES

48 of 118

Airbus, China and Quid Pro Quo

• Airbus was negotiating to build an assembly line for a new passenger plane in China.

• The deal would have a significant effect on its business dealings there.

• Producing European planes in China would give Airbus an advantage in the battle with Boeing for the world’s next great aviation market.

• Airbus has 344 planes in service in China, Hong Kong, and Macao, but Boeing still dominates with nearly 2/3 of the market.


HEADLINES

49 of 118

Airbus, China and Quid Pro Quo

• Airbus’ move shows the lengths it is willing to go to break into China’s market, despite being active there since 1985 without success.

• Boeing has no plans to build a production line in China, but has still won orders to supply many of its 737s to Chinese carriers.

• Airbus could greatly aid Europe in cultivating commercial ties with China.

• Chinese and French leaders celebrate visits to each other with the signing of aircraft deals.



• Effect of a Subsidy to Airbus Suppose the European governments provide a subsidy

of $25 million to Airbus to produce. This increases Airbus’ profits by $25 million when it

produces.

• Best Strategy for Airbus and Boeing In fact, Airbus is better off producing, now matter what

Boeing does. Boeing recognizes this and stays out of the market. The bottom left corner is the only Nash equilibrium.



Figure 10.6



• European Welfare The subsidy has a big impact on the equilibrium of the

game, but is Europe better off?

Since Europe is producing for the rest of the world, there is no consumer surplus in Europe.

Airbus’ profits have increased from $0 to $125 million.

The revenue cost of the subsidy is $25 million.

The net gain in European welfare is +$100 million. The increase in profits are greater than the cost of the subsidy.


Subsidy with Cost Advantage for Boeing

• What about cost differences? Let us now consider another case in which Boeing has

a cost advantage over Airbus. Assume the advantage is not from a subsidy, but due to

U.S. comparative advantage in aircraft production. This gives another payoff matrix in figure 10.7. Boeing earns profits of $5 million when both firms

produce, and profits of $125 million when Airbus does not produce.

The only Nash equilibrium—the upper right quadrant—is where Boeing produces and Airbus does not.



Figure 10.7



• Can we have both? Now suppose the European government provides the

$25 million subsidy to Airbus but Boeing still has the cost advantage.

Best Strategy for Airbus With the subsidy in place, and Boeing producing, the best

decision for Airbus is to produce and earn profits of $20 million.

Best Strategy for Boeing Given that Airbus produces, Boeing earns profits of $5 million

when it produces and $0 when it does not.

Therefore, Boeing will stay in the market. Both firms producing is now the new Nash equilibrium.



Figure 10.8



• European Welfare Once Again When Boeing has the cost advantage, the European

subsidy allows Airbus to enter the market. This has not resulted in the exit of Boeing as it did in

the earlier no-cost-advantage scenario. Airbus’ profits have increased from $0 to $20 million. The revenue cost of the subsidy to Europe is still $25

million. The net gain in European welfare is now -$5 million. When Boeing has the cost advantage, the subsidy

leads to a net loss in European welfare.



• Summary Under conditions of imperfect competition, a subsidy by

one government to its exporting firm might increase welfare for its nation or it might not.

There is an increase in welfare only if profits rise by more than the cost of the subsidy.

This is more likely satisfied if the subsidy leads to the exit of the other firm.

However, if both firms remain in the market, it is unlikely that the increase in profits for the subsidized firm will exceed the subsidy cost.


APPLICATION

59 of 118

Subsidies to Commercial Aircraft

• The U.S. and Europe have used various types of subsidies to support their respective firms:1. Indirect subsidies that arise because the R&D for

military versions effectively subsidize R&D for civilian aircraft.

2. The government might directly subsidize the R&D costs of a new aircraft, as Europe subsidizes R&D at Airbus.

3. The government can subsidize the interest rates that aircraft buyers pay when they borrow money to purchase aircrafts. Europe and the U.S. both provide low interest loans to aircraft

purchasers.


APPLICATION

60 of 118


• 1992 Agreement Development subsidies are now limited to 33% of the total

development costs of a new aircraft. Limits indirect (military) subsidies to not more than 4% of any

firm’s annual sales. Prohibits production subsidies. Limits the ability of government agencies to subsidize the interest

rate on purchases of aircrafts.

• Reducing subsidies led to a rise in prices for aircraft by 3.1% and 8.8%. Governments benefit from not having to pay the subsidies. Higher prices help firms but hurt importing countries.


APPLICATION

61 of 118


• The Super Jumbo There are claims that the terms of the agreement are

being violated by Airbus. It is selling a new aircraft, the double-decker A380,

which is larger than the Boeing 747 and competes directly with it.

The expenditures to develop the A380 are estimated at $12 billion.

The European governments provided about $3.5 billion in low-interest loans to cover development costs.


APPLICATION

62 of 118


• The Super Jumbo In 2005, both the U.S. and the EU filed counter-

complaints at the WTO regarding illegal subsidies by the other party to their respective aircraft producers.

Europe was accused of “illegally” subsidizing the A380, while the U.S. was accused of subsidizing the development of Boeing’s 787 commercial jet.

The complaints charged that these subsidies violate the 1992 agreement. The U.S. is calling for termination of the agreement.


APPLICATION

63 of 118


• National Welfare Will the subsidies to Airbus increase national welfare? From the previous information, it is more likely to

happen if Airbus is the only firm producing in that market.

Boeing has announced it will not produce a double-decker like the A380.

It will instead modify its current 747 and focus R&D on its new 787 “Dreamliner” aircraft.


APPLICATION

64 of 118


• National Welfare Since Boeing will not enter the double-decker market, it

is possible the profits earned by Airbus will cover the subsidy. Of course that assumes the Boeing plane is not more of a direct

competitor to the Airbus. The profits earned will depend on how many are sold

and at what price. Airbus says it needs to produce at least 250 planes to

cover development costs, but expects to sell 1,500 over the next 20 years.

As of April 2006, it has orders for only 159 and many of those has been discounted at least 10%.


APPLICATION

65 of 118


• National Welfare In mid-June 2006, Airbus told its buyers it could not

deliver as promised—delays of 6 months or more. Several of the largest customers entered into

discussions to seek compensations for the delay. Singapore Airlines announced it would order the Boeing

787 “Dreamliner” instead. The stock price of Airbus’ parent company, EADS, fell

by more than one-quarter of its value in a single day.


APPLICATION

66 of 118


• These events do not mean the Airbus A380 will fail; delays happen often in this industry.

• These events do, however, illustrate the intensity of the competition in the airline industry.

• This competition benefits consumers who will be traveling on the new aircraft.

• However, competition makes it more difficult for government subsidies to be recovered in profits

Documents

EXPORT SUBSIDIES IN AGRICULTURE AND HIGH-TECHNOLOGY INDUSTRIES 1 WTO Goals 2 Agricultural Export Subsidies in Small Country 3 Agricultural Export Subsidies