You have become a (well-paid) consultant to the EU on trade policy. The EU is an

Question

You have become a (well-paid) consultant to the EU on trade policy. The EU is an importer of Steel and an exporter of Cars. Suppose that you are choosing between advocating an import tariff on steel and an export subsidy on cars. If you assume perfect competition on each of these markets, which of the trade policies – the import tariff on steel or the export subsidy on cars – can potentially increase welfare (total surplus) in the EU? The EU is considered to be a large “country” in both these markets. Motivate briefly.

Explanation / Answer

If EU uses export subsidy, price of the car increases in the domestic market and decreases at the international market. As price increases in the domestic market, consumers in the domestic market pay a higher price to avail a car than the consumers of the rest of the world pay. Therefore, consumer surplus decreases. On the other hand, producers of car in EU receive a higher price as a result of the subsidy. Producer surplus increases as a result. Therefore, car production in EU increases along with rises in employment. Per capita income associated with the export and related sector increases. However, the effect on government spending is uncertain. If the government provides subsidy from its budget, then it increases spending and hence, there may be a budget deficit. If the government increases tax rate to compensate the subsidy, then it reduces national welfare as higher taxes reduces disposable income and purchasing power in later period. Hence, it can be stated that export subsidy would increase the producer surplus but would reduce the national welfare of the EU.

When the large country like EU increases import tariff, it raises the price of steel in the domestic market in comparison to the price of steel in the international market. Tariff reduces the consumer welfare on EU consumers as they have to pay higher price compared to consumers of the rest of the world. Producer surplus increases on the contrary as they receives higher price. Government of the EU receives tariff revenue due to imposition of tariff on steel import. This tariff revenue may be used by the Government for investing in the welfare program in EU. This spending is mainly targeted for the unprivileged group in the economy. When a large economy like EU imposes import tariff, it increases national welfare. However, too high tariff rate can reduce that welfare.

Therefore, In a competitive market, import tariff is more effective than export subsidy when total welfare of EU is concerned.

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