Question

Suppose that Country X subsidizes its exports and Country Y imposes a “countervailing” tariff that offsets the subsidy’s effect, so that in the end, relative prices in Country Y are unchanged. What happens to the terms of trade? What about welfare in the two countries? Suppose, on the other hand, that Country Y retaliates with an export subsidy of its own. Contrast the result.

Answer 1

Suppose Country X subsidizes its exports and Country Y imposes a countervailing tariff which offsets the subsidy's effect. Since the prices of both the countries change by the same amount, the ratio of the prices, which is the terms of trade remains unaffected. However, the welfare of the countries falls since a cheaper good is expensive in country Y and despite providing subsidies, country X cannot gain the benefit of increased exports.

Now, if country Y retaliates, the terms of trade will remain the same but the volume of trade will fall significantly if both the countries are large countries. However, if X is a small country then the term of trade will move in favor of country Y.

The contrast to the result is that the first situation's outcomes are independent of the country being large or small. In the second case, what happens to terms of trade highly depends up on the size of the countries.