Question

Production subsidy vs. tariff

A country is considering a tariff or a production subsidy to protect a domestic industry from imports.

1. a) Assuming the production subsidy is the same % as the tariff, which policy is preferable if we consider only the dead-weight loss? Draw graphs that support the argument.

2. b) If the policy-maker’s only concern is redistributing gains from trade (not an infant industry argument), identify one other policy she could pursue? In 1 or 2 sentences explain how that policy achieves the stated goal.

Answer 1

B). Empirical evidence suggests that trade gains are not equally distributed over the economy and that some groups are even worse off.1 To ensure political support for international integration, it is thus argued that the government should redistribute income towards those individuals who are
harmed by trade liberalization. Based on this argument and on the public discussion about the possible implications, economists have analyzed the effects of different redistribution schemes in many different situations. One conclusion is that
redistribution leads to a (partial) compensation for the harmed individuals, but is also accompanied by a reduction of welfare. Therefore, the best strategy for the government is to minimize the welfare loss for an ex ante-defined level of compensation (or vice versa).