Question

Assume Dacia and Tracia are two big counties producing food and cloth. If Dacia subsidizes its exports and Tracia imposes a “countervailing” tariff that offsets the subsidy effect so that in the end relative prices in Tracia are unchanged:

            i) What happens with the terms of trade and the welfare in the two countries?

            ii)Suppose that Tracia retaliates with an export subsidy. Contrast the result.

Refer to the world relative supply and demand graph to support your answer.

Answer 1

In this questions we have been informed that Dacia and Tracia are two big counties producing food and cloth and Dacia subsidizes its exports and Tracia imposes a countervailing tariff that offsets the subsidy effect so that in the end relative prices in Tracia are unchanged

i) The impact on the Terms of trade and the welfare in the two countries will be as follows :

The terms of trade capture the relative cost of imports in terms of exports. If the prices of exports increase relative to the prices of imports, the terms of trade have improved because the country will be able to purchase more imports with the same amount of exports. In contrast, if the price of exports decreases relative to the price of imports, the terms of trade have deteriorated because the country will be able to purchase fewer imports with the same amount of exports. In the given question terms of trade have deteriorated because the export price is reduced because of the subsidy and also the import price have increase because of tariff. Welfare will be reduced in both the countries.

ii)If Tracia retaliates with an export subsidy

In that case the terms of trade will be favorable for both the countries because both the countries will get the import at lower cost.