Question

Suppose the world price of banana is P* and Ecuador decides to offer its banana exporters an export subsidy $s/unit. Use a graph of domestic demand- and supply-curves and:

(a) show the effect of the export subsidy on Ecuador's banana price, domestic supply, domestic demand, export quantity, consumer surplus, producer surplus, and government expenditure assuming Ecuador is a small country;
(b) identify Ecuador's net welfare change as a result of the export subsidy assuming Ecuador is a small country;

(c) Assuming a production subsidy is used instead, show the effect of the production subsidy on Ecuador’s banana price, domestic supply, domestic demand, export quantity, consumer surplus, producer surplus, government expenditure and total welfare assuming Ecuador is a small country.

(d) Between export subsidy and production subsidy, which would be preferred by the consumers?

(e) Between export subsidy and production subsidy, which would be preferred by the domestic producers?

(f) Between export subsidy and production subsidy, which would be more desirable to the country?

Answer 1

A) Export Subsidy case

So, domestic price increases to Psubsidy

Domestic supply falls as producers prefer exporting – Q2 to Q4

Domestic demand falls amid higher domestic prices – Q1 to Q3

Export Quantity increases – Earlier exported (Q2-Q1), now exporting (Q4-Q3)

Consumer surplus falls by area (a+b)

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

Govt expenditure rises by area (b+c+d)

B) Net welfare change= Consumer surplus+ Producer surplus + Govt expenditure

                                         = -a-b+a+b+c-b-c-d

                                        = -(b+d), Hence net loss

C) Production Subsidy

So, domestic price falls to P`

Domestic supply falls as more is exported amid high world prices- Q2 to Q4

Domestic demand rises as production subsidy reduces domestic price – Q1 to Q3

Export Quantity decreases– Earlier exported (Q2-Q1), now exporting (Q4-Q3)

Consumer surplus increases by area (a+b)

Producer surplus falls by area (a+b+c+e)

Govt expenditure rises by area (a+b+c)

Net welfare change= Consumer surplus+ Producer surplus + Govt expenditure

                                         = a+b-a-b-c-e-b-c-a

                                        = -(2c+e+a), Hence net loss

D) Consumer prefer production subsidy as it increase consumer surplus by reducing price

E) Domestic producer prefer export subsidy as it increase producer surplus by increasing domestic price

F) Govt pay same amount, so its neutral