This paper focuses on the effect of output subsidies in an economic union in the context of a third-market model where there are two countries which produce a homogeneous good consumed in a third country. We study the importance of cost asymmetry between firms in different countries, and the elasticity of demand in the case of countries that join an economic union with harmonized output subsidies. We find that the optimal level of subsidy in the economic union can be negative (a tax) if firms have different costs and the demand is concave. We also compare the optimal subsidy in the economic union with the pre-union export subsidies with the result that the new policy generally favours the less efficient countries.
JEL Classification (F13)