Question

Assume that country X subsidizes its exports and country Y imposes a countervailing tariff that offset the subsidy. Explain why the relative prices in country Y would be unchanged. Discuss the welfare effects in the two countries. What would be the effect if country Y retaliates with an export subsidy but without countervailing tariffs on the product?

Answer 1

*Answer:

Step-by-step solution

1. Step 1 of 1

   Subsidies and tariffs are the two economic instruments on which countries rely on to support the domestic industries. But these policies have opposite effects on the terms of trade. If country Xoffers subsidy on the value of exported goods, given the world prices, this subsidy will raise its internal price of exportable goods. This will lead to country X’s producers to produce more exportable goods and consumers to consume more importable goods. But, this subsidy will increase the world relative supply of exportable goods but reduces its world relative demand; thereby reducing the world relative prices of exportable goods. So, a subsidy will worsen the country X’s terms of trade and improves that of country Y.

   Now, if country Y imposes a countervailing import tariff to affect less its internal relative prices, then the situation for country X still worsens because an import tariff deteriorates the terms of trade of the country X which exports and improves that of country Y. So, we can infer that both, a home subsidy and a foreign tariff will negatively affect the terms of trade of country X. But, a home tariff and a foreign subsidy benefits country Y. If country Y retaliates with export subsidy of its own, then the initial benefits received by country Y will start deteriorating as a home subsidy for any country will worsen its terms of trade. This will reduce the welfare of country Y and increase that of country X.

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