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Individual Paper of
The Effect of Subsidies on Trade
Prepared By
Abed El-Azez Safi (January, 2010)

Under the Supervision of
Prof. Maria Luigia Segnana, Dr. Andrea Fracasso and Dr. Giuseppe Vittucci
1. Introduction
This individual paper aims to provide the different definitions which used for subsidies. It also
addresses the main economic effects and briefly reviews of the use of subsidies in the empirical
evidence of positive and negative effects of subsidies on welfare in a few specific cases.
2. The Definition of Subsidies
We can define subsidies under GATT, Tokyo Round and WTO which agree with Subsidies and
Countervailing Measures (SCM) and Agreement of Agriculture (AOA).
Under WTO rules, subsidies may be prohibited, actionable, or non-actionable, The WTO prohibits
the most subsidies directly which linked to the volume of exports.
One should notice that, there is no common definition of a subsidy. Its difficult to define the term
subsidy, as reflected in the frequently quoted statement by Hendrik S. Houthakker: My own
starting point was also an attempt to define subsidies. But in the course of doing so, I came to the
conclusion that the concept of a subsidy is just too elusive
But if we look at (Deardorff's Glossary of International Economics) A payment by government,
perhaps implicit, to the private sector in return for some activity that it wants to reward, encourage, or
assist.
And for (Oxford online dictionary) a sum of money granted from public funds to help an industry or
business keep the price of a commodity or service low
A large number of government programmes may be considered as subsidies, these programmes can be
grouped into three categories:
! Government may transfer funds to producers or consumers (direct payments, etc).
! Government may provide goods or services without cost or below market price, such as
university education, public transport or food stamps.
! Regulatory policies may be seen as subsidies (tax concessions, etc).
3. The Economics of Subsidies
Subsidies can be regarded as a form of protectionism or trade barrier by making domestic goods and
services artificially competitive against imports. Introducing a subsidy or some other government
measure within a perfect market framework will be inefficient and welfare-diminishing as it creates a
distortion leading to a misallocation of resources across alternative uses and over time. But if the
perfect market assumption is relaxed, situations may arise where a government measure like a subsidy
improves welfare. An efficient subsidy would correct a market failure, bringing social and private
costs and benefits into alignment.
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Suppose that a government decided to protect a particular domestic industry on the grounds that there
were learning-by-doing effects associated with the activity from which the wider economy would
benefit, and that these benefits were not properly reflected by the market so that the private agents
end with producing too little. In this case, a government might choose between imposing a tariff on
competing imports and directly subsidizing the industry concerned. A tariff would raise the domestic
price of imports and allow the protected industrys output price to rise to the same level of import
price. Domestic consumers would then have to pay the higher price. But if a subsidy were used, the
domestic price would still be the duty-free import price, and the subsidy received by the domestic
industry would allow it to compete with imports at world prices. Consumers would not be taxed, and
the subsidy option would be regarded as the more efficient one. This is an application for the theory of
optimal intervention (Johnson 1965; Bhagwati 1971).
3.1. Perfect Competition Case

If a market is assumed to be perfect and closed to international trade, production subsidies to firms
have the effect of expanding output, reducing the price paid by consumers and creating an overall
welfare loss, since resources will be allocated inefficiently. Introducing international trade into this
scenario complicates matters. For example, an important distinction is whether the subsidy is granted
to an import competing or export competing industry. If it is the former and assuming world prices are
unaffected, since the country is assumed to be small, the domestic price is fixed by the world price
and cannot change, the end result will be an expansion in domestic output at the expense of imports.

3.1.1 Trade effects of production subsidies
In the diagram below domestic supply is given by S0, domestic demand by d0 and world price of the
product is given by p*. Since the world price is below the price that would clear the domestic market,
the total quantity demanded of the product oQd would be satisfied by oQ0 units of domestic
production and Q0Qd of imports.

If the government, for political or redistributive reasons, decides that the level of domestic production
should be oQ1 instead of oQ0, it has to then decide whether or not to use a tariff or a subsidy to
expand production. If it uses a subsidy, and assuming it cannot affect world price, domestic supply
will shift from S0 to S1 causing domestic production to expand to the desired level and imports to fall
by Q0Q1. Prior to the subsidy, domestic output was at point Q0. Since additional domestic output
beyond that level would cost less to source from the world market, the government will have achieved
the desired level of output, but the resource implications for the economy will be negative. The
additional cost to the economy is represented by the area abc.
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Therefore, a welfare loss arises from the application of the subsidy, since the subsidy creates a wedge
between the optimal price (world price) and the actual price paid to domestic producers.
Now consider the case of an export subsidy to an industry. Both production and export subsidies may
have the effect of expanding domestic output and exports. They differ, however, in their effects on
domestic prices. Domestic prices are unaffected by producer subsidies but rise in the case of export
subsidies if re-imports are prevented. Costs to the taxpayer in the export subsidy case will also be
lower than in the production subsidy scenario since the volume of subsidised domestic consumption
will be lower. This occurs because domestic prices rise with the export subsidy, causing quantity
demanded to fall.
With the small country assumption, therefore, the key international trade insight is that quantities
adjust in response to the subsidy intervention. In the domestic production subsidy case, imports
contract or exports expand, whereas in the export subsidy case exports expand. Inefficiencies arise in
both cases since a portion of domestic output is determined by the subsidy-inclusive price, as opposed
to the world price.
In the two cases considered above, the subsidizing country was assumed to be a price-taker in the
world economy. This means that economic changes within the country will not have any impact on
world prices. If this assumption is relaxed, output will still increase as in the small economy case
described above. This time, however, the disequilibrium caused by the subsidies will also cause price
effects in international markets. If more output is exported as a result of an export subsidy, then world
prices will fall. Domestic prices, however, will rise, since some of the output will still have to be sold
domestically and there is less quantity available in the market.
3.1.2 Export subsidy in a large country case
An export subsidy creates an incentive for producers to supply for export as opposed to domestic
consumption. The withdrawal of supply from the domestic market causes domestic prices to rise. At
the same time, since supply to the world market has increased, world prices fall. If the re-importation
of goods into the domestic market from the world market is prevented, a wedge between the domestic
price and the world price is created.
The overall impact of the export subsidy on the home country is decidedly negative. Domestic
consumers pay a higher price for a product that they are blocked from sourcing at a lower price from
the world market. This leads to welfare losses for consumers. Domestic producers are direct
beneficiaries from the policy, since their production has expanded as a result of the subsidy.
Consumers in the foreign country benefit from lower world prices. Foreign producers, however, are
net losers, since they now have to compete with the lower prices. Uncompetitive producers will be
forced to exit the industry. Overall, however, the country is better off, since the increased benefit to
consumers offset the loss to the producers.

3.2 Imperfect Competition Case

3.2.1 Economies of scale
The figure (1) below depicts a monopoly firm and is based on Grossman (1990). Without a subsidy,
the firm is unable to produce profitably, since the price it would charge (p*) is below its average cost
(point b). Total welfare would, by definition, be zero since no output is produced or consumed. Now
suppose the government provides a subsidy to the firm of the amount p*abc. This induces the firm to
produce a total amount of oQ*. Consumer welfare is the area dcp*, which in this diagram is greater
than the cost of the subsidy. That is implying that average costs fall with increased output.
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3.2.2 Externalities
In the Figure (2) below, suppose the private domestic supply and demand curves are given,
respectively, by S0 and d0. Consequently, with a world price of p*, equilibrium quantities produced
and consumed are Q0 and Qd. Now suppose that the production process is characterised by a positive
externality that is not taken into account. As a result, the initial supply curve is not representative of
the benefits of production. The social costs of producing each unit would be lower than what is
portrayed by the supply curve S0, which shows only the private cost. If the externalities are taken into
account, the new supply curve would be S1, which indicates a lower unit cost of production.
If the world price and the demand curve are assumed to reflect the true social costs, then the domestic
production of the good at Q0 would be less than the socially optimal level of production Q1. The cost
to society of this underproduction would be the area cde. To see this, assume a total subsidy of the
amount dfgp* is provided, which expands output to Q1. The total cost of the imports being replaced
as a result of the subsidy is Q0Q1dc, but the total cost to society from producing the incremental
output would be Q0Q1de. The difference is the area cde.
Therefore, if a positive externality in production exists, a production subsidy could be used to increase
welfare. Again, a tariff would be inferior to a subsidy as an instrument of intervention, since it would
distort consumption and increase the cost to society of producing the expanded output.

Figure (1) Figure (2)
We have seen that the overall impact in production subsidy a welfare loss arises from the application
of the subsidy, since the subsidy creates a wedge between the optimal price (world price) and the
actual price paid to domestic producers, and in export subsidy is negative at home country, since
domestic consumers pay a higher price for a product that they are blocked from sourcing at a lower
price from the world market. this leads to welfare losses for consumers. But if a positive externality in
production exists, a production subsidy could be used to increase welfare.
4. A Case Study on the Effects of Subsidy

4.1 The externality in fisheries

The issue of fishery subsides is receiving growing attention. The WTO Ministerial declaration agreed
at Doha in 2001 commits WTO Members to negotiations to clarify and improve WTO disciplines on
fisheries subsidies. In 2002 at the world Summit on Sustainable developments, Heads of State
called for the elimination of environmentally harmful fisheries subsidies.
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The reason is that marine resources have deteriorated severely over the last 30 years and subsidies
arising from government efforts to preserve employment in the shipbuilding and fishing industry, for
example, have been blamed as one of the factors responsible for the overcapacity of fleets and the
over-exploitation of fish stocks.
4.2 Fishery subsidies in Senegal
The fishing industry is Senegals largest source of foreign exchange. Fishery exports in 2003
amounted to US$282 million, constituting 24 per cent of total merchandise exports in 2003, and 4.3
per cent of GDP. Fishing is the second most important source of employment, accounting for 15 per
cent of the economically active population. Fish also provide
the Senegalese population with 75 per cent of their animal proteins. Food security is, therefore, an
important policy objective of the government in respect of its fishery sector. Historically, government
assistance to the fishery sector has seen two main phases. In the 1970s, support to the sector took
the form of direct production subsidies to industrial fishing. Subsequently, the government turned to
subsidizing small-scale fishing. At first, support to small-scale fishing was in the form of subsidies
targeted to increasing output by means of encouraging the introduction of better equipment,
modernization of vessels and improving infrastructure. Thereafter, state financial assistance to fishing
was aimed at providing marketing support and encouraging exports. free-trade zones and duty-free
export company status, the lom Convention, export subsidies, fisheries agreements and
devaluation all contributed significantly towards increasing exports. According to recent estimates
(UNEP, 2004), during the 1990s and until today the main modalities for granting fisheries subsidies in
Senegal have been:
Tax reductions on fishing equipment for the modernization of pirogues. The accumulated amount
granted by the government is estimated at CFAF 2.01 billion (approximately US$2.7 million).
A fuel subsidy for the enhancement of fishing equipment and to prolong sea trips and open up
fishing areas. the fuel subsidy to small-scale fishing alone rose from less than CFAF 2 billion in 1986
to over CFAF 6 billion in 1998 (approximately US$10 million).
Subsidies to small-scale fishing through the Caisse Nationale de Crdit Agricole du Sngal
(CNCAS), the funds portfolio has remained below CFAF 3.2 billion in ten years of intervention in
the sector.
Subsides to industrial fishing through the Fonds de Promotion Economique (FPE). this includes: (i)
an economic advancement fund, which is a credit line of CFAF 39 billion; (ii) a guarantee fund (to
cover risks involved in lending to SMES); and (iii) a participatory loans fund of CFAF 3 billion set
up by the State to offset inadequate equity of entrepreneurs.
Investments in infrastructures, including the construction of fishing wharves and the creation of the
Central fish Market (CFM). The latter was built in 1992 at a cost of CFAF 3 billion (90 per cent was
financed by Japan). The CFM was enlarged in 1998 at a total cost of over CFAF 3 billion (99 per cent
financed by Japan).
Export subsidies (until 1994). By way of example, export subsidies to the trawler fishing industry
in the fiscal year 1991/1992 amounted to CFAF 12 billion (approximately US$18 million).
In 1995, a subsidy of CFAF 1.7 billion was granted to some 30 Senegalese companies as a means
of financing up to 30 per cent of their investments to adapt to European standards, in cooperation with
Cooperation Franaise.
Senegal has concluded many fishing agreements with foreign countries, by far the most
important among them being those with Japan and the European Union. Those with Japan relate
mainly to tuna, while those with the European Union concern coastal demersal and, more recently,
'
pelagic fisheries. The European Communitys total financial contribution to Senegal is of !16 million
a year during 2002-2006.


4.2.1 The effect of Senegal subsidy
Fisheries subsidies are firmly on the international agenda. It has been argued that fisheries access
agreement s is the kinds of subsidy that have most impact on developing countries. These subsidies
have both positive which providing marketing support and encouraging exports and increasing stock
depletion of animal proteins for the domestic market, and decreasing the prices of product and extend
free-trade zones and duty-free export company, but negative impacts which are very site and context
specific. Whilst there appears to be a general consensus that subsidies inevitably lead to over-
exploitation of fish stocks and by implication negative social and economic impacts, this is not
necessarily the case. A more important factor appears to be the existence of an effective fisheries
management system, which in some cases is paid for by subsidies. It is clear that the removal of
subsidies alone will not solve the problem of over-exploited fisheries.
5. Conclusion
This paper provides several definitions of subsidies. Subsidies play an important role in making
domestic goods and services artificially competitive against import. They have also positive and
negative effects on the price system and consumer consumption.
From theoretical point of view, we have seen that in case of perfect competition the effects of
subsidizing are always negative. Therefore, in case of imperfect competition there may be positive
effects in two cases of economies of scale and externalities.
In term of externalities case there is too much negative effect but in the case of Senegal fishery it
appears positive effect in labour protection, and in economies of scale it decreases the price of the
product and open free-trade zone and duty-free export company and increase the output of the
product.
6. References
Bhagwati, J. (1971) the Generalised theory of distortions and welfare, in J. Bhagwati et.
al (EDS), Trade, Balance of Payments, and Growth: Papers in International Economics in
honour of Charles P. Kindleberger , Amsterdam: North Holland.
Deardorff's Glossary, http://www-personal.umich.edu/~alandear/glossary/.
Grossman, G. (1990) promoting new industrial activities: a survey of recent arguments and
evidence, OECD Economic Studies, No. 14, paris: oeCd.
International Fish Trade and Food Security, Case of Senegal,
http://www.fao.org/DOCREP/006/Y4961E/y4961e0i.htm
Johnson, H. (1965) optimal trade Intervention in the presence of domestic distortions,
in Baldwin et al, Trade, Growth and the Balance of Payments, Amsterdam: North-Holland
press.
WORLD TRADE REPORT 2006, Exploring the links between subsidies, trade and the WTO,
World Trade Organization, 2006
10, January 2010