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Export subsidies

TABLE OF CONTENTS

Introduction 3

Research Methodology 5

Chapter 1: What are Export Subsidies? 6

Chapter 2: The US vs. EU 10

Chapter 3: The Effect on Developing Countries 14

Conclusion 19

Bibliography 20

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INTRODUCTIONExport subsidies are incentives provided by the government to producers who export

their goods to foreign countries. These producers could be anyone ranging from huge

firms to cottage industries to poor farmers with small land holdings. Due to these

subsidies the producers have some motivation to produce more goods which leads to

increaser in the stockpile. The government either buys the surplus from this supply by

itself or provides concessions on tax or factors of production. After this the surplus

amount is exported to other countries to strengthen the foreign exchange reserves.

Therefore subsidization encourages production activities and also helps in alleviating

poverty among small producers.

However the problem due to export subsidies occurs when the export price is set way

above the domestic price. This is quite unfair to the domestic consumers plus it leads to

losses to the producers in the foreign market. To counter this infiltration, the foreign

government introduces its own set of subsidies which shall further lead to changes in

subsidies by the domestic government to form a kind of repeated game.

All these problems get multiplied in a real-life international market since every country is

trying to get the best for themselves which leads to disputes. These kinds of problems

generally arise between developed and developing nations. Here, the developed country

tries to dump all its goods into the small but roaring markets of the developing nations.

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As for these developing nations, they want to keep their market protected from dumping

by the developed countries. Thus both the nations either complain to the WTO or else try

to negotiate between themselves. Obviously it is the developing nations who suffer more

owing to the fact that they aren’t in a very strong economical or political situation

compared to the developed nations.

Therefore subsidies have to be carefully monitored and judiciously implemented for

actual welfare. This can be done by investments in Research & Development to gain

some knowledge about rival firms’ costs to gain the upper hand.

This paper shall further elaborate upon the various aspects of export subsidies. The paper

also discusses the advantages and disadvantages associated with these subsidies. Finally

it deals with some examples of export subsidies in the international market and their

consequences upon the various countries.

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RESEARCH METHODOLOGYAIMS AND OBJECTIVES

This aim of this paper is to study the concept of export subsidies by analyzing the

European Union’s export subsidies and their effects on developing countries. The

underlying objective is to understand the role of export subsidies in international trade

practice.

SCOPE AND LIMITATIONS

This paper undertakes a case study of the European Union’s export subsidies only. Export

subsidies of other countries are not dealt with in this paper. However, a theoretical

understanding of export subsidies has also been undertaken in order to aid in the case

study.

RESEARCH QUESTIONS

What are Export Subsidies?

What are the advantages and disadvantages of Export Subsidies?

What led to the Peace Clause?

How are developing nations affected by export subsidies?

CHAPTERIZATION

The paper is divided into three chapters

Chapter 1: This chapter describes the general working of export subsidies and the

advantages and disadvantages associated with them.

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Chapter 2: This chapter talks about the US and EU dispute over subsidies.

Chapter 3: This chapter elaborates upon the effects of export subsidies on developing

countries.

SOURCES OF DATA

The researcher has primarily relied on secondary sources like books and articles for

information.

STYLE OF WRITING

The researcher has adopted a descriptive and analytical style of writing for this paper.

MODE OF CITATION

A uniform mode of citation has been followed throughout the paper.

Chapter 1

What are Export Subsidies?

In layman terms export subsidies are bonuses granted to producers who export their

products to foreign countries. These are granted for various reasons like encouraging

firms or individuals like farmers to produce more goods so that consumer demand is

totally fulfilled and the surplus is exported, to capture a foreign market by exporting

cheap subsidized products to it, and to help poverty-stricken farmers earn a living since

through subsidies they are guaranteed some amount of profit since the government bears

the burden of loss for them. The government too readily provides these subsidies to

exporters so as to increase the country’s foreign exchange reserves and inventory stocks.

Subsidizing goods also helps in protecting the domestic producers against foreign

competitors and dumping of goods by them.

To further understand how export subsidies lead to welfare some economic models have

been discussed. The economists Itoh and Kiyono used a model to show that subsidies on

marginal goods, i.e. goods which are not exported or exported in minimal quantities can

increase welfare in the subsidizing country. According to their model, a subsidy on

marginal goods will lead to increase in their production and the supply of non marginal

goods would decrease. This in turn, shall lead to increase in the prices of the non

marginal goods and increase in the exporter’s terms of trade. Similarly, Feenstra also

demonstrated the role of substitutability and complementarity across subsidized goods to

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increase welfare. According to him, the subsidized exported good should be a stronger

substitute for another exported good or a stronger complement for an imported good in

the subsidizing country and this increases welfare by improving the terms of trade in the

other imported or exported good1

Export subsidies are implemented by the government through various means. The most

common ones are tax concessions and reduction in the costs of the factors of production

like transport, electricity, raw materials.

There are essentially two types of export subsidies:2

1. Specific Export Subsidy: The subsidy provided is based on a fixed sum per unit. For

example a specific amount of concession is granted to

producers for every unit they export. This gives the

producers an incentive to produce more units and export

them.

2. Ad Valorem Export Subsidy: The subsidy provided is calculated as a proportion of

the total value exported. For example the total subsidy

for a firm is determined as a proportion of the total

value of goods exported which is normally quite

large.

Therefore well crafted and targeted subsidies can successfully correct imbalances in the

market provided that they are withdrawn gradually when their benefits have been realized

since they can prove to be quite detrimental in the long run. The domestic consumers are

the ones who lose out since the domestic price is far more than the export price. 3 Thus

the government should invest in research to gain information as to what products to

subsidize and in what quantities. Research shall also help the government to gain

knowledge about foreign firms trying to enter the market. With this information dumping

can easily be prevented and these firms can be kept in check.

1 Julian M. Alston, Colin A. Carter and Vincent H. Smith, “Rationalizing Agricultural Export Subsidies”, 75(4), American Journal of Agricultural Economics 1000, 1000 (1993).2 Paul R. Krugman and Maurice Obstfeld, International Economics 197-198 (Delhi: Pearson Education, 2004).3 PC Bansil, Agricultural Incentives in India 39 (Bruno Dorin and Thomas Jullien ed., New Delhi: Manohar Publishers, 2004).

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Once a subsidy has been decided by the government the producers shall export the goods

till the domestic price exceeds the foreign price by the amount of the subsidy provided.

This can be further explained with the following graph:

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Due to subsidization the price in the exporting country shall rise from Pw to Ps since

more exports would lead to decrease in their own country’s supply. Similarly price in the

importing country shall decrease from Pw to Pt since the supply in their markets shall

increase. Therefore in the exporting country the producers might earn profits but the

consumers shall suffer losses along with the government since it is them who have to

bear the brunt of subsidies. In the graph consumer loss is equal to the area – (a + b) and

the producer gain is given by the area a + b + c. Meanwhile the government subsidy is

calculated as the area of – (b + c + d + e + f + g). Thus the net welfare loss amounts to

area of b + d + e + f + g. Therefore it is quite evident that the costs of export subsidies

exceed its benefits.4 Export subsidies are also a key factor in international trade disputes

since all nations want their markets to be protected against foreign firms. These shall be

discussed further in the project.

4 Supra note 2.

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Chapter 2

The US vs EU

Europe had never been a large producer of agricultural goods and had to import many

products to meet the consumer demand. Therefore the European Union (EU) decided to

take some steps to increase agricultural produce so that they can be self-sufficient when it

comes to food stock and also become an exporter of these agricultural products. So the

EU formulated a Common Agricultural Policy (CAP) which was initially meant to help

out its farmers by buying their products whenever the prices fell below specified support

levels. This policy was simple and quite successful as the agricultural produce increased

since now the farmers were not afraid of making losses and also many more people

started large scale farming.

However, this policy too had some drawbacks and so it has been morphed into a massive

export subsidy program now. The basic problem with CAP was that the support prices set

by EU were so high that the European farmers had too much of an incentive to produce

more stock than needed. The gravity of this can be realized from the fact that had this

been a free trade situation European countries would have had to import most agricultural

products. However due to implementation of CAP, EU was obliged to buy the entire

surplus produced by its farmers. Now EU was having problems in storing such huge

quantities of perishable goods. At the end of 1985, European nations had a surplus stock

of 780,000 tons of beef, 1.2 million tons of butter and 12 million tons of wheat. The

European nations realized that exporting is the only profitable way to get rid of this

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enormous stockpile. Therefore to make exporting possible, CAP was gradually modified

into an export subsidy program.5 The working of CAP can be further explained with the

help of the following graph:

5 Supra note 2.

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The graph indicates that the support price under CAP is fixed above both the world price

that would prevail in its absence and the equilibrium price without any imports. Thus to

export the resulting surplus, an export subsidy is paid which further enlarges the

difference between European and world prices. Meanwhile the subsidized exports tend to

reduce the world price since an excess amount of cheap products is released into

international markets. This loss in the world price leads to further increase in subsidies

since more of surplus goods can be sold off at a lower price. Therefore it is quite evident

that the combined costs of CAP to European consumers and taxpayers are far more than

the benefit to producers. Despite this fact, CAP has hardly been challenged by the

European consumers and authorities since the political strength of farmers in EU is quite

strong and influential.6

However, CAP has been criticized on the international level. The United States and other

food-exporting nations have always demanded a change in EU policy since European

export subsidies drive down the prices of their own exports. In fact during the Uruguay

round of trade negotiations, the USA initially demanded a complete end to European

subsidies by the year 2000. Later, after long negotiations these demands were

considerably reduced but even then the opposition by European farmers was so strong

that it nearly led to the collapse of these negotiations. In the end EU agreed to cut

subsidies by about a third over six years.7

6 Supra note 2, at 199.7 Supra note 2, at 199.

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Finally these disputes among the EU and USA came to an end when they both agreed to

the Peace Clause. As predictable none of the developing countries like India were a party

to it since the peace clause prevented these nations from protecting their markets from

European subsidized exports. Under the peace clause, EU is provided a subsidy waiver

such that the agricultural export subsidies being granted under the EU’s Common

Agriculture Policy cannot be challenged till the year 2003. Thus the peace clause proved

to be quite beneficial to the European countries and they shall definitely try to extend the

provisions granted to them under peace clause in the future. Meanwhile the US too shall

not reduce its export subsidies as was believed earlier. In fact it is believed that US would

also increase its subsidies under various exemptions granted under WTO.8

8 Devinder Sharma, The Great Grain Drain, 79 (Bangalore: Books for change, 1998).

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Chapter 3

The Effect on Developing Countries

As discussed in the previous sections export subsidies have a lot of disadvantages to

them. They lead to consumer losses in the domestic market while the foreign market is

flooded with cheap surplus production which leads to losses for the foreign firms.

Subsidization also creates imbalances in the market and can lead to losses to the

government. Now that subsidies are the norm, therefore most countries are affected by

them but the nations which are most affected by such subsidies are developing nations.

The WTO has always encouraged free trade through their policies; however these

policies prove beneficial only for the developed countries. As for the developing nations,

they have to compete with major powers like US and EU who tend to dump their goods

into these countries leading to losses for the producers in these developing countries.

Since a complete free market is too idealistic a situation to achieve, therefore subsidies

are still implemented across the world. Unfortunately it’s the developing nations who

lose out since they cannot compete with the highly subsidized goods of the developed

nations no matter how much subsidies they implement. Furthermore the developed

nations and the WTO have always tried to get the developing nations to decrease their

subsidies leading to an open market for exports.

The basic problem when it comes to export subsidies arises due to the fact that the export

price is set way below the domestic price. As discussed before this is quite unfair to the

domestic consumers plus it leads to losses to the producers in the foreign market. To

counter this infiltration, the foreign government introduces its own set of subsidies which

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shall further lead to changes in subsidies by the domestic government to form a kind of

repeated game. To understand this situation further, a simple payoff matrix is drawn:

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The given payoff matrix shows the various payoffs associated with developed and

developing countries based on their choices to implement subsidies or not. In the first cell

when both nations provide subsidies, the developed nation would obviously have a higher

payoff than the developing nation. Similarly in the second cell, the developed nation shall

profit more due to subsidization while the developing nation shall suffer losses due to non

subsidization. Plus, dumping of goods might also occur in this case. The third cell

describes the situation when none of the countries implement subsidies and how both

countries shall receive their normal payoffs. Finally in the fourth cell, the developed

nation would not be able to capture the market since it does not implement any subsidies

while the developing nation shall get a high payoff.

From the above discussion, it’s clear that the given game is an example of prisoner’s

dilemma. To elaborate further, both the nations have a dominant strategy to implement

subsidization since the payoffs associated with it are higher than the payoffs associated

with non-implementation of subsidies. However, the optimal strategy lies in the third cell

when no subsidies are used by either nation. This justifies the general belief that the

market should be left alone and subsidies should be completely scrapped. Though

admittedly those would be too drastic a step to be taken at this point of time, but

nevertheless it’s a viable option for the future.

As a consolation to developing nations an alternative take on this can be the fact that at

least their consumers get access to international standard goods at subsidized prices.

However if we believe that the tradeoff between this benefit to consumers of the

developing nations and the benefit to producers of the developed nations can be justified,

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it is totally wrong because the benefit acquired by the consumers is too miniscule

compared to the mammoth profits acquired by the producers of the developed nations

plus the losses suffered by the firms of developing nations. Therefore it is the developing

nations which fall prey to the wrath of subsidies.

While the developed nations like the US maintain that they plan to phase out export

subsidies, what they actually do is replace these producer subsidies by processor

subsidies which would be passed back to producers anyways. Since these countries are

too strong economically and politically, they cannot be out rightly opposed by other

countries on international forums since most of the other countries do depend on these

powerful nations for monetary or military aid. Thus these countries implement their trade

policies without any strong objections. Moreover these countries want the developing

nations to remove their trade barriers so that they can dump their subsidized surplus

products into these markets.9 The WTO too has similar plans. It prohibits various kinds of

subsidies like government direct subsidies, export bonuses, concessions on factors of

production, etc. Plus, export dumping too has been legitimized till quite a large amount.

Thus the picture is quite grim for developing nations. Particularly in the agricultural field

where countries like India do provide subsidies to farmers, but these are not implemented

efficiently and instead of helping poor farmers its actually increasing the wealth of the

middlemen and farmers who are already effluent. Obviously the Indian farmers cannot

compete with the multinational companies of the developed nations who also get large

subsidies in return. These MNCs can easily dump cheap grains into the Indian market

which shall lead to destabilization of the market and loss of livelihood to numerous

farmers.10

To counter these ill effects of subsidies the government should try and negotiate with

WTO and the developed nations to get its point across. Plans should be formulated to

attain self-sufficiency in basic sectors. This would also help the economy because even if

it’s a free market, free and fair trade would happen in both countries. Proper planning and

research on various markets are the need of the hour since firms are unlikely to have

complete information about the costs of their foreign competitors. Therefore if the 9 Supra note 8.10 Supra note 8, at 77.

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domestic government invests in R&D it can intervene in this situation since it would

obviously have more information about the costs of the domestic firm than the foreign

firm. The domestic government can then implement an export subsidy to signal the

competitiveness of the domestic firm. Now a larger export subsidy shall lead the foreign

firm to believe that the domestic firm has lower costs and so it shall reduce its output

which leads to increase in profits of the domestic firm.11 Therefore implementation of

subsidies should be properly supervised and judiciously implemented provided that its

backed up by research and valuable information.

11 David Collie and Morten Hviid, “Export Subsidies as Signals of Competitiveness”, 95(3), The Scandinavian Journal of Economics 327, 327-337 (1993).

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CONCLUSIONAfter the completion of this project the researcher has come to certain conclusions.

Export subsidies do lead to welfare but only if they are supervised properly. Moreover its

cons easily outweigh its pros therefore the best strategy is to invest in research and

development so that the best plan of action can be chosen keeping the information

furnished by research in mind. Are export subsidies really worth taking the troubles

associated with them? This is the question being asked on the international level as well.

Many disputes over subsidies are taking place all around the world. The most important

of them all was the US-EU dispute over EU’s subsidies which finally came to an end

with the signing of the Peace Clause which like most other international trade policies

was a policy favoring free trade and thus suited for the developed nations. Developing

nations are the ones who actually suffer due to these disputes since they do not have the

clout in the international circles to enforce their way. Thus these developing nations

should formulate a strategy based on research, planning, negotiations and efficient use of

subsidies to hold their own against the developed nations. This tussle between the

developed and developing nations leads to a sort of repeated game which reinforces the

belief that markets should be left alone and subsidies should be scrapped. However, this

is too idealistic a view and therefore the governments should rather aim at keeping

subsidies to a minimal level.

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BIBLIOGRAPHY

BOOKS:

1. Paul R. Krugman and Maurice Obstfeld, International Economics (Delhi: Pearson Education, 2004).

2. PC Bansil, Agricultural Incentives in India (Bruno Dorin and Thomas Jullien ed., New Delhi: Manohar Publishers, 2004).

3. Devinder Sharma, The Great Grain Drain, (Bangalore: Books for change, 1998).

ARTICLES:

1. Julian M. Alston, Colin A. Carter and Vincent H. Smith, “Rationalizing Agricultural Export Subsidies”, 75(4), American Journal of Agricultural Economics (1993).

2. David Collie and Morten Hviid, “Export Subsidies as Signals of Competitiveness”, 95(3), The Scandinavian Journal of Economics (1993).

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