Question

4. Explain what would happen to the terms of trade should home offer a subsidy to home producers that export to the rest of the world under the two set of assumptions below (10 points, 5 points for each case):
   1. Home is considered a large country (hence, it is able to affect world prices)
   2. Home is considered a small country (unable to affect world prices)

(Note: Assume no counter-action by foreign countries.)

Answer 1

4.

A.

When subsidy is given to the producers in the large country, then cost of production decreases and these firms are able to export goods at a lower price. As a result, export from the large country will increase since the world price is higher than the price of export from the large country. As a result, a new world price will be set that will be at a lower level. So, subsidies in the large country, will decrease the world price.

B.

When subsidy is given to the producers in the small country, then cost of production will decrease in the small country. Since, the world price is at a higher level, then domestic producers will export more to the rest of the world at a world price. As a result, consumers in the domestic country will get products at a higher price, because domestic producers will first export, and then sell it to the domestic consumers. As a result, world price will cause rise in price in the small country.