Export Subsidies in High-Tech Industries December 1, 2016
Subsidies to commercial aircraft In the large passenger aircraft market, there are two large firms: Boeing in the U.S. (which merged with McDonnell-Douglas in 1997) Airbus in Europe. U.S. and Europe have used various types of subsidies to support their respective firms: Directly subsidize the R&D costs of a new aircraft Indirect subsidies for commercial aircraft via R&D expenditures on military aircrafts. Provide low interest loans or subsidize the interest rates to aircraft purchasers. 2
1992 agreement Realizing that subsidies are costly, U.S. and Europe reached an agreement in 1992 to limit them. Development subsidies now limited to 33% of the total development costs of a new aircraft. It is expected that these subsidies will be paid back at the government interest rate. 1992 agreement Limits indirect (military) subsidies to not more than 4% of any firm s annual sales Prohibits production subsidies Limits the ability of government agencies to subsidize the interest rate on purchases of aircrafts 3
Provisions of the1992 agreement Source: Feenstra & Taylor, 2011 4
Results of the 1992 agreement The agreement reduced subsidies by 7.5-12.5 % of total production costs. Reducing subsidies led to a rise in prices for aircraft by 3.1-8.8%. Governments benefited from no longer paying the subsidies. Higher prices helped the firms, but led to welfare losses for purchasing countries. 5
Subsidies to high-tech industries Subsidies to high-tech industries are common beyond the commercial aircraft industry. Japan and South Korea give direct subsidies to their hightech manufacturing firms and encourage them to reach certain targets for export sales. One reason that governments support high-tech industries is because of the possible spillover benefits to other areas of the economy. Governments believe there is a positive externality that exists from the production of high-tech products, so subsidizing them increases production and also increases the positive externality. 6
Governments argue subsidies might give a strategic advantage to exporting firms which compete with a small number of rivals in international markets. If high-tech subsidies allow firms to compete more effectively and earn more profits in the international market, and if extra profits are greater than the subsidy, then the exporting country has an overall gain. This is similar to the benefit a large country can get from a tariff. 7
A simple model To analyze the effects of export subsidies in high-tech industries, we will consider an imperfectly competitive market structure: A duopoly with two large high-tech firms: Airbus and Boeing Each firm can set the price and quantity of its product, taking as given its rival s price and quantity choices. We then examine the effects of strategic export subsidies in determining whether the profits of the exporting firm will rise enough to offset the cost of the subsidy to the government. To capture strategic decision making of two firms, we will use game theory. 8
We begin with free trade. Two firms are competing for sales of a new type of aircraft. We will focus on the decision of each firm to develop the new aircraft that competes with the aircraft of the other firm for sales to the rest of the world. We will ignore sales in their own countries, so we do not have to keep track of consumer surplus. Welfare is only dependent on the profits earned by Boeing or Airbus from sales to the rest of the world. 9
Payoff matrix The next figure shows a payoff matrix for Boeing and Airbus. Each producer must decide whether or not to produce the new aircraft. Each quadrant of the matrix shows the profit earned by Boeing in the lower-left corner. The profits of Airbus are in the upper-right corner. 10
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Best strategies What is Boeing s best strategy if Airbus chooses to produce? In this case, Boeing is clearly better off not producing. This gives a profit of $0, rather than a profit of -$5 million. This tells us that BOTH firms producing is NOT a Nash Equilibrium. What is Boeing s best strategy if Airbus chooses not to produce? In this case, Boeing is clearly better off by producing. This gives a profit of $100, rather than a profit of $0 million. Everything is symmetric for Airbus. Airbus is better off by producing if Boeing chooses not to produce, and by not producing if Boeing chooses to produce. 12
Multiple Nash equilibria We have a Nash Equilibrium when each firm is making its best decision given what the other firm is doing. Hence, two Nash equilibria: Airbus produces and Boeing does not (i.e., the bottom left quadrant of the payoff matrix) Boeing produces and Airbus does not (i.e., the upper right quadrant of the payoff matrix) 13
Multiple Nash equilibria When there are two Nash equilibria, then there must be some force that determines which one we are in. One of these is the first mover advantage, i.e. if one firm is able to decide whether or not to produce before the other firm. Suppose we start at the Nash equilibrium in the upperright quadrant. Because Airbus is not producing and making $0 profits, the government in Europe might want to try to change the equilibrium so that Airbus would earn positive profits. The government might want Airbus to produce. 14
Export subsidy The European government might decide to provide subsidies to Airbus to achieve this. What happens to the payoff matrix, if anything, in such a case? The type of subsidy we will consider is a cash payment to Airbus. But in practice we know that subsidies can take on many forms. 15
Effect of a Subsidy to Airbus Suppose the European governments provide a subsidy of $25 million to Airbus to produce. This increases Airbus profits by $25 million when it produces. The following figure shows the new payoff matrix. Remember that under free trade, two Nash equilibria existed in which one firm produced and the other did not. 16
Strategic Use of High-Tech Export Subsidies 17
Best strategy for Airbus Let s begin with the Nash Equilibrium in which Boeing produces and Airbus does not. After the subsidy, this is no longer a Nash equilibrium. If Boeing is producing, then Airbus is now better off by also producing because of the $25 million subsidy. With the subsidy it now earns $20 million even when Boeing produces ($25 subsidy - $5 losses). 18
Nash equilibrium It is easy to check that the outcome in the the lower-left quadrant is a Nash equilibrium. Each firm is making its best decision, given the action of the other. It is also the only Nash equilibrium in this game. The effect of the government subsidy has been to shift the equilibrium from having Boeing as the only producer, to Airbus as the only producer. 19
European welfare The subsidy has a big impact on the equilibrium of the game, but is Europe better off? We can add up the welfare of various parties involved. Since Europe is producing for the rest of the world, there is no consumer surplus in Europe. There are two cases to consider. If the initial equilibrium was one in which Airbus produced but Boeing did not, then the only effect of the subsidy would be to make this equilibrium unique. The net effect of the subsidy on the European Welfare would be zero, since it would be a transfer from the European government to Airbus. 20
European welfare In contrast, if the initial equilibrium was the one in which Boeing produced but Airbus did not, then subsidy has a net effect on European Welfare. Airbus profits have increased from $0 to $125 million. The revenue cost of the subsidy is $25 million. The net gain in European welfare is +$100 million. The increase in profits are greater than the cost of the subsidy. 21
What about cost differences? Let us now consider another case in which Boeing has a cost advantage over Airbus. Assume the advantage is not from a subsidy, but due to U.S. comparative advantage in aircraft production. This gives another payoff matrix as in the next figure. Boeing earns profits of $5 million when both firms produce, and profits of $125 million when Airbus does not produce. The only Nash equilibrium is now the one in the upper right quadrant, where Boeing produces and Airbus does not. 22
Cost Advantage for Boeing 23
Subsidy with Cost Advantage for Boeing Now suppose the European government provides the $25 million subsidy to Airbus but Boeing still has the cost advantage. Best Strategy for Airbus With the subsidy in place, and Boeing producing, the best decision for Airbus is to produce and earn profits of $20 million. Best Strategy for Boeing Given that Airbus produces, Boeing earns profits of $5 million when it produces and $0 when it does not. Therefore, Boeing will stay in the market. Both firms producing is now the new Nash equilibrium. 24
Subsidy with Cost Advantage for Boeing 25
European welfare once again When Boeing has the cost advantage, the European subsidy allows Airbus to enter the market. This has not resulted in the exit of Boeing as it did in the earlier no-cost-advantage scenario. Airbus profits have increased from $0 to $20 million. The revenue cost of the subsidy to Europe is still $25 million. The net gain in European welfare is now -$5 million. When Boeing has the cost advantage, the subsidy leads to a net loss in European welfare. 26
As a result Under conditions of imperfect competition, a subsidy by one government to its exporting firm might increase welfare for its nation. There is an increase in welfare only if profits rise by more than the cost of the subsidy. This is more likely satisfied if the subsidy leads to the exit of the other firm. However, if both firms remain in the market, it is unlikely that the increase in profits for the subsidized firm will exceed the subsidy cost. 27
Back to the 1992 agreement: The super jumbo There were claims that the terms of the agreement were violated by Airbus. Airbus new aircraft, the double-decker A380, which is larger than the Boeing 747, competes directly with it. The expenditures to develop the A380 are estimated at $12 billion. The European governments provided about $3.5 billion in low-interest loans to cover development costs. 28
In 2005, both the U.S. and the EU filed countercomplaints at the WTO regarding illegal subsidies by the other party to their respective aircraft producers. Europe was accused of illegally subsidizing the A380, while the U.S. was accused of subsidizing the development of Boeing s 787 commercial jet. The complaints charged that these subsidies violate the 1992 agreement. The U.S. is calling for termination of the agreement. 29
National welfare Will the subsidies to Airbus increase national welfare? From the previous information, it is more likely to happen if Airbus is the only firm producing in that market. Boeing has announced it will not produce a doubledecker like the A380. It will instead modify its current 747 and focus R&D on its new 787 Dreamliner aircraft. 30
Since Boeing will not enter the double-decker market, it is possible the profits earned by Airbus will cover the subsidy. Of course that assumes the Boeing plane is not more of a direct competitor to the Airbus. The profits earned will depend on how many are sold and at what price. Airbus says it needs to produce at least 250 planes to cover development costs, but expects to sell 1,500 over the next 20 years. As of January 2010, it had delivered only 25 of 202 aircraft ordered and was experiencing significant delays in production. 31
Several of the largest customers entered into discussions to seek compensations for the delay. Singapore Airlines announced it would order the Boeing 787 Dreamliner instead. The stock price of Airbus parent company, EADS, fell by more than one-quarter of its value in a single day. 32
These events do not mean the Airbus A380 will fail; delays happen often in this industry. These events do, however, illustrate the intensity of the competition in the airline industry. This competition benefits consumers who will be traveling on the new aircraft. However, competition makes it more difficult for government subsidies to be recovered in profits. Due to the production delays, Airbus parent company, EADS, lost value on the market. Recently Airbus has struggled with many problems on the production of their A380. Boeing on the other hand has been successful in orders on its new 787 Dreamliner ramping up the competition for Airbus. 33
Problems in new aircraft development is not unique to Airbus. In 1990, Boeing had to shut down assembly lines and lost an assembly system due to issues with keeping suppliers and deliveries on time. It also appears that Boeing may be having early problems and delays in development of the 787, but still claims they will have on time deliveries. 34