International Trade - Theory and Policy, 2010a

consider a large importing country initially in free trade. Because it is in free trade, there is a market
imperfection present that has not been taken advantage of. Suppose this country’s government
implements a production subsidy provided to the domestic import-competing firm. We can work out the
effects of this production subsidy in Figure 9.7 "Domestic Production Subsidy by a Large Importing Country".
Figure 9.7 Domestic Production Subsidy by a Large Importing Country
The free trade price is given by PFT. The domestic supply in free trade is S 1 , and domestic demand is D 1 ,
which determines imports in free trade as D 1 − S 1 (the red line in Figure 9.7 "Domestic Production Subsidy by
a Large Importing Country").
When a specific production subsidy is imposed, the producer’s price rises, at first by the value of the
subsidy. The consumer’s price is initially unaffected. This increase in the producer’s price induces the
producer to increase its supply to the market. The supply rises along the supply curve and imports begin
to fall. However, because the country is a large importer, the decrease in imports represents a decrease in
the world demand for the product. As a result, the world price of the good falls, which in turn means that
the price paid by consumers in the import market also falls. When a new equilibrium is reached, the
producer’s price will have risen (to PP in Figure 9.7 "Domestic Production Subsidy by a Large Importing
Country"), the consumer’s price will have fallen (to PW), and the difference between the producer and
consumer prices will be equal to the value of the specific subsidy (s = PP − PW). Note that the production
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