(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, what happens to the nation's consumer surplus as a result of the $100 export subsidy?
A) It increases by $2,500.
B) It decreases by -$1,875.
C) It decreases by $725.
D) It decreases by $2,500.

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, what happens to the nation's consumer surplus as a result of the $100 export subsidy?
A) It increases by $2,500. 
B) It decreases by -$1,875. 
C) It decreases by $725. 
D) It decreases by $2,500.

Quizplus · Accepted Answer

When a subsidy is introduced, the domestic producers are induced to increase production of the subsidized good, which causes a decrease in world price. On the graph, the world price decreases from Pw1 to Pw2. As a result of this, home demand increases from Qh1 to Qh2 and home supply decreases from Qh1 to Qw2.

The consumer surplus is the area above the world price, below the demand curve, and to the left of the quantity purchased. Before the subsidy is introduced, the consumer surplus is the triangle A+B+C. After the subsidy is introduced, the consumer surplus is the triangle A. The change in consumer surplus is the area B+C.

The area B represents the loss from the increased price that consumers must pay. The area C represents the gain from the increase in quantity consumed. The change in consumer surplus is negative because B is larger than C.

The magnitude of the change in consumer surplus is equal to the difference between the consumer surplus before the subsidy and the consumer surplus after the subsidy. This is given by:

Change in Consumer Surplus = [0.5(Pw1 - Pw2)(Qh1 - Qw2)] - [0.5(Pw1 - D(Qh2))(Qh2 - Qw2)]

Plugging in numbers, we get:

Change in Consumer Surplus = [0.5(900 - 700)(4,000 - 2,500)] - [0.5(900 - 500)(3,500 - 2,500)]
Change in Consumer Surplus = -$1,875

Therefore, the answer is B: It decreases by -$1,875.

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