Social welfare function and the hidden costs of sanctions

This study examines the unintended effects of sanctions on energy-producing countries and their impacts on both sanctioning and third-party states. Through formal modelling, we develop a microeconomic network framework with energy producers operating downstream and manufacturers upstream. Within this structure, we distinguish between compliant and neutral third-party countries—those that continue trading with sanctioned nations and, in doing so, weaken the sanctions’ effectiveness. We derive a closed-form solution that demonstrates social welfare losses are proportional to the number of neutral states. Notably, we show small increases in per-unit production costs from disrupted supply chains reduce consumer surplus more than the removal of a single firm. At the firm level, we find that sanctions raise input costs more than they reduce market competition, suggesting that losing access to key suppliers harms sanctioning countries more than facing fewer rivals. This reveals a critical unintended consequence: neutral countries exploiting arbitrage opportunities can impose greater welfare losses on senders than on targets. Our analysis quantifies these externalities and shows that supply-side distortions outweigh any competitive gains. By presenting a network-based microeconomic framework, the paper complements macroeconomic perspectives and deepens understanding of how neutrality and fragmented markets undermine sanction effectiveness