(Figure: Home's Exporting Industry II) The graph shows the effect of a subsidy on a large country. D describes home demand and S describes home supply. According to the graph, if the home country provides a subsidy of $100, the large country will cause the world price to:
A) increase by $50.
B) increase by $150.
C) decrease by $50.
D) decrease by $150.

Question

(Figure: Home's Exporting Industry II) The graph shows the effect of a subsidy on a large country. D describes home demand and S describes home supply.  According to the graph, if the home country provides a subsidy of $100, the large country will cause the world price to:
A) increase by $50. 
B) increase by $150. 
C) decrease by $50. 
D) decrease by $150.

Quizplus · Accepted Answer

When the home country provides a subsidy, the supply curve shifts to the right (from S to S+subsidy). This causes the quantity of exports from the home country to increase from Q1 to Q2. However, since the home country is large enough to affect the world price, this increase in exports causes the world supply curve to shift to the right (from S* to S*+subsidy), which lowers the world price from P1 to P2. The home country's producers now receive the original world price (P1) plus the subsidy ($100), which is more than the new world price (P2). As a result, some domestic producers who were not previously exporting at P1 will now start exporting at P2, which increases the quantity of exports from the home country even more. However, this further decreases the world price, canceling out some of the initial increase. In the end, the world price will decrease by less than the amount of the subsidy, which is $50 ($100 subsidy/2 inelasticity of world demand curve), so the correct answer is C.

(Figure: Home's Exporting Industry II) the Graph Shows the Effect