10 EXPORT SUBSIDIES IN AGRICULTURE AND HIGH TECHNOLOGY

10 EXPORT SUBSIDIES IN AGRICULTURE AND HIGH -TECHNOLOGY INDUSTRIES 1 WTO Goals 2 Agricultural Export Subsidies in Small Country 3 Agricultural Export Subsidies in Large Country 4 Agricultural Production Subsidies 5 High-Tech Export Subsidies 6 Conclusions

Introduction • In December 2005, representatives of the 149 countries belonging to the WTO met in Hong Kong to discuss reforms of the world trading system. • The main focus of these meetings was the trade policy (tariffs and subsidies) on agricultural products. w Lower world prices hurt farmers in land-rich developing countries like Brazil, India, and China. w But lower world prices benefit land-poor developing countries that import agricultural products. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 2

Introduction • The first goal of this chapter is to explain agricultural subsidy policies. • The primary reason for agricultural export subsidies is political. • Examine how export subsidies can be used strategically by governments to bolster domestic companies and industries w E. g. high-tech industries • Legislators often believe that subsidies to high-tech industries might raise their profits and benefit the exporting countries. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 3

WTO Goals on Agricultural Export Subsidies • Agricultural Export Subsidies w An export subsidy is a payment to a firm for every unit exported. § A fixed amount or a fraction of the sales price. w Governments give subsidies to encourage domestic firms to increase production in particular industries. w Europe maintains a system of agricultural subsides known as the Common Agricultural Policy (CAP). § As a result, the sugar beet subsidy makes Europe a leading supplier of sugar, even though other countries have a natural comparative advantage over Europe. w Other countries maintain similarly generous subsidies. § U. S. pays cotton farmers to grow more cotton and subsidizes agribusiness and manufacturers to buy the American cotton. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 4

WTO Goals on Agricultural Export Subsidies • Domestic Farm Supports w These include any assistance given to farmers, even if it is not directly tied to exports. w These programs can still have an indirect effect on exports by lowering production costs, and therefore the competitiveness, of domestic products. • Cotton Subsidies w Export subsidies in cotton received special attention because that crop is exported by many low-income African countries and is highly subsidized in the U. S. w Although the U. S. agreed to eliminate them, it still leaves open other domestic supports to cotton not directly tied to exports. • Let’s look at the effects of export subsidies on a “small” country. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 5

Agricultural Export Subsidies in a Small Home Country Figure 10. 1 The free trade equilibrium at world price PW, gives (without subsidy) exports of X 1 and a horizontal Foreign import demand. Equilibrium is at B. Home Price World Price S D Home export supply X B PW Foreign import demand A D 1 X 1 S 1 Quantity X 1 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 6

Agricultural Export Subsidies in a Small Home Country • Impact of an Export Subsidy w Suppose the government wants to boost domestic exports of sugar. § Each ton of sugar exported receives a subsidy, s. w Exporters will receive PW+s for each ton exported. w Domestic price must rise to PW+s, otherwise firms will not sell any output domestically. w Home consumers could just import sugar at the world price, PW. w Therefore, Home will impose a tariff equal to or higher than the amount of the export subsidy. § This typically happens and, is therefore, realistic. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 7

Agricultural Export Subsidies in a Small Home Country • Impact of an Export Subsidy w The combined effect of the subsidy and the tariff is to raise the price at Home. w Exports increase due to two factors: § Higher domestic price (movement along supply curve). § Subsidy (shifts the export supply curve). w Production and Consumption effects. w As with a tariff, the subsidy has driven a wedge between what domestic exporters receive (PW+s), and what importers abroad pay (PW). © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 8

Agricultural Export Subsidies in a Small Home Country Figure 10. 1 (with subsidy) This. Home decreases to D 2, shifts increases to S 2 the , and The exportdemand supply curve downsupply by exactly increases exports to Xthe. Equilibrium atfalls C. to by amount ofthe subsidy. of production s. With subsidy, Home priceisrises PWexactly +s 2 MC Home Price World Price X S D X–s C PW+s B s PW C' s A D 2 D 1 X 2 S 1 S 2 Quantity X 1 X 2 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 9

Agricultural Export Subsidies in a Small Home Country • Impact of the Subsidy on Home Welfare w The rise in price lowers consumer surplus by (a+b). w The rise in price raises producer surplus by (a+b+c). w The export subsidy costs the government the amount of the subsidy, s, times the amount of exports, X 2 shown by (b+c+d). w Adding up this impact, we are left with a net effect on Home welfare of –(b+d). § b is the production loss or efficiency loss for the economy. § d is the consumer loss for the economy. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 10

Agricultural Export Subsidies in a Small Home Country Figure 10. 1 The increased price decreases consumer surplus by (a+b) (with welfare effects) Producer surplus increases by (a+b+c) The subsidy costs the government the amount –(b+c+d) This leaves us with a deadweight loss of (b+d) as before. Home Price World Price S D b d PW+s a s Total deadweight loss, b+d C X X–s B c PW C' s A D 2 D 1 X 2 S 1 S 2 Quantity X 1 X 2 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 11

Agricultural Export Subsidies in a Large Home Country • Now suppose Home is large enough that its subsidy affects the world price of sugar. w Foreign export demand curve, M*, is downward sloping. • Note that the new world price, P*, is less than PW although the new Home price is PW+s. w Home terms of trade fall but foreign terms of trade rise. • Since Home terms of trade fall, the Home country will suffer overall losses. • Foreign consumers will gain. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 12

Agricultural Export Subsidies in a Large Home Country Figure 10. 2 (with subsidy) We begin in free trade equilibrium Home demand applies adecreases subsidy, shifting and home the export supply increases curve leading right by to the amountexports, increased of the subsidy, X 2 s The new world price is at new equilibrium, P*. New Home price is P*+s (a) Home Market (b) World Market Home Price World Price D Home exports supply, X S X 2 P*+s s X 1 s X–s PW P* Foreign import demand, M* D 2 D 1 S 2 Quantity X 1 X 2 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 13

Agricultural Export Subsidies in a Large Home Country • Home Welfare w The higher Home price reduces consumer surplus by (a+b). w Additionally, the higher price increases producer surplus by (a+b+c). w We also need to consider the cost of the subsidy—the amount of the subsidy times the exports after the subsidy, area (b+c+d+e). w This gives a net welfare loss of (b+d+e). w Area e represents the terms of trade loss. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 14

Agricultural Export Subsidies in a Large Home Country Figure 10. 2 Consumer surplus falls by -(a+b). (with subsidy) Producer surplus increases by +(a+b+c). Home Price Home Welfare D b P*+s S This leaves a net deadweight loss of (b+d+e), greater than in a small country. c a s d The subsidy costs the government (b+c+d+e): subsidy times exports. PW e P* D 2 D 1 S 2 Quantity © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 15

Agricultural Export Subsidies in a Large Home Country • Foreign and World Welfare w From Home’s perspective, the terms of trade loss is just (e), but when we move to foreign welfare next, it will be useful to break up (e) into the two parts e’ and f. w The price of Foreign imports decreases leading to an increase in Foreign consumer surplus by (e′). w Combining Home welfare loss of (b+d+e) and subtracting Foreign terms-of-trade gain (e′), there is an overall deadweight loss for the world, (b+d+f) in panel b. w The area (f) is the additional world deadweight loss due to the subsidy. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 16

Agricultural Export Subsidies in a Large Home Country Figure 10. 2 World Consumer surplus rises by -(e’) which is a terms of trade gain With Home welfare loss of (b+d+e) and Foreign terms-of-trade gain (e’), there is World an overall loss for the worldterms of of f is an additional lossdeadweight due to decrease in Home’s (b+d+f) in completely panel b trade not offset by increases in World’s terms of trade (without subsidy) (a) Home Market (b) World Market Home Price World Price D b P*+s S b+d c a s d Home exports supply, X s PW e X–s f e' P* Foreign import demand, M* D 2 D 1 S 2 Quantity X 1 X 2 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 17

Agricultural Export Subsidies in a Large Home Country • Foreign and World Welfare w This transfer of terms of trade is what countries sometimes use to make subsides sound like good ideas to “aid” poorer countries. w However, the deadweight loss (f) means using the export subsidy to increase exports is an inefficient way to transfer gains from trade among countries. w It would be more efficient to just give cash aid to the poorer countries. § Cash does not change trade levels so would not have deadweight loss of (b+d+f). § This is why the European countries eliminated transfers of food as a form of aid several years ago. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 18

Who Gains and Who Loses? APPLICATION • Let’s return to the Hong Kong meeting of the WTO in December 2005 to see which countries will gain and which will lose when the export subsidies are eliminated by 2013. • Gains w Obvious winners will be current agricultural exporters in developing countries such as Brazil, Argentina, Indonesia, and Thailand, along with potential exporters such as India and China. w These countries will gain even more when and if an agreement is reached on eliminating agricultural tariffs in the industrial countries. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 19

Who Gains and Who Loses? APPLICATION • Gains w These actions will also benefit industrial countries, suffering from deadweight losses and terms-of-trade losses from the combination of subsidies and tariffs. w Clearly the farmers in industrial countries who lose the subsidies will be worse off. § Given that it is usually the largest farmers who gain the most from subsidy programs, they may be better able to adjust to the elimination of subsidies than smaller farmers. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 20

Who Gains and Who Loses? APPLICATION • Losses w Given that eliminating subsidies will typically lead to increased world prices, food-importing countries, typically the poorer non-food producing countries, will lose. w One study finds that the existing pattern of agricultural supports raises the per-capita income of two-thirds of 77 developing nations, including most of the poorest countries such as Burundi and Zambia. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 21

Who Gains and Who Loses? APPLICATION • Losses w Figure 10. 3 shows some of these results. w Poor countries are net importers of essential food items such as corn, rise, and wheat, and would be harmed by an increase in their world price. w Many of the world’s poorest individuals depend on cereal crops for much of their diet and would be especially hard hit by any increase in those prices. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 22

Who Gains and Who Loses? APPLICATION Figure 10. 3 © 2008 Worth Publishers ▪

Agricultural Production Subsidies • The agreements reached in Hong Kong distinguish between export subsidies in agriculture and all other forms of domestic support that increase production. w Tax incentives and other types of subsidies • This is because it is expected that these other forms have less impact on exports than do direct subsidies. • In this section, therefore, we will examine the impact of a production subsidy in agriculture for both a small and a large country. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 25

Agricultural Production Subsidies • A production subsidy is when the government provides a subsidy of s dollars for every unit that a Home firm produces. w It is a subsidy to every unit produced, not just to units exported. • The subsidy can be implemented by the government: w guaranteeing a minimum price to the farmer. w providing subsidies to the users of the crop to purchase it, thereby increasing demand for the crop and the price. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 26

Agricultural Production Subsidies • These policies all fall under Article XVI of the GATT. • This states that partner countries should be notified of the extent of such subsidies, and where possible, these subsidies should be limited. • In Hong Kong, the WTO members further agreed to classify countries according to the extent of such subsidies. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 27

Agricultural Production Subsidies • Effect of a Production Subsidy in a Small Home Country w We have a small country with a fixed world price of PW. w There is a subsidy of s increasing Home price to producers to PW+s. w Quantity demanded at home does not change since producers still charge the world price at Home. w This happens because Home producers receive the subsidy no matter who they sell to. w The production subsidy increases exports by less than an export subsidy. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 28

Agricultural Production Subsidies Figure 10. 4 (with production subsidy) Subsidy to producers increasing supply to We can increases see in (b) price that Home export supply increases, S-s producing S 2. Home quantity demanded showing that exports increase from X 1 to X 2. does This not is a change. smaller increase than with an export subsidy since Home demand does not change. (a) Home Market (b) World Market Home Price World Price X D S S-s X’ C PW+s s B PW C' D 1 S 2 Quantity X 1 X 2 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 29

Agricultural Production Subsidies • Home Welfare w Producer surplus rises by (a+b) in panel a. w Government cost of the subsidy is (a+b+c) – the amount of subsidy s times total production S 2. w Consumer surplus is unaffected since quantity demanded is unaffected. w This leaves a new effect on Home welfare of (–c). w The deadweight loss caused by the production subsidy, (c), is less than that caused by the export subsidy, (b+d). w The only deadweight loss is in production inefficiency— producers produce at higher than marginal cost. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 30

Agricultural Production Subsidies Figure 10. 4 (with welfare effects) Home producer surplus rises by (a+b) Subsidy costs government (a+b+c) Deadweight loss from production subsidy is c, which is less than with export subsidy of (b+d) in figure 10. 1. (a) Home Market (b) World Market Home Price World Price X D S S-s C PW+s a s b PW X’ B c C' D 1 S 2 Quantity X 1 X 2 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 31

Agricultural Production Subsidies • Targeting Principle w Since the deadweight loss is lower for this subsidy than for the export subsidy, it makes a better policy instrument for the purpose of increasing Home supply. w This is an example of the targeting principle. § To achieve some objective, it is best to use the policy instrument that achieves the objective most directly. w To use an example from this book, it is better to provide trade adjustment assistance directly to those affected, than to impost a tariff or quota. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 32

Agricultural Production Subsidies • Effect of Production Subsidy in a Large Home Country w We will not draw this case in detail but will use figure 10. 4 to briefly explain. w Price rises from PW to PW+s, and Home production increases to S 2. w Since demand has not changed, exports increase by the same amount as the change in Home supply. w The rise in exports from B to C′ is less than the increase in exports with an export subsidy, from B to C. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 33

Agricultural Production Subsidies Production Subsidy for a Large Home Country W+san export This increase inan exports (B toin. C′) less than we curve saw with Thesee production subsidy leads to is increase in price to P We this as increase the export supply from X to X’ subsidy (B to C). and increased productionfrom to SB 2 increasing exports by S 1 -S 2 changing the equilibrium to C’ (a) Home Market (b) World Market Home Price World Price X D S S-s X’ C PW+s s B PW C' ΔX D 1 S 2 Quantity X 1 X 2 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor Exports 34

Agricultural Production Subsidies • Effect of Production Subsidy in a Large Home Country w In the export supply subsidy, the increase in exports occurred due to the increase in supply and the decrease in demand. § The export supply curve shifted down by the exact amount of the subsidy, s, (as in figure 10. 1). § With a production subsidy, the exports increased only due to the increase in Home production. § The export supply curve then shifted down by an amount less than s, (as in figure 10. 4). © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 35

Agricultural Production Subsidies • Effect of Production Subsidy in a Large Home Country w If we draw a downward-sloping foreign import demand curve in panel b, then the increase in supply due to the production subsidy would lower the world price. w But the drop in world price would be less than the drop that occurred with the export subsidy, since the increase in exports is less. • Production subsidies in agriculture still lower world prices, but by less than export subsidies. • Therefore, the WTO is less concerned about eliminating production subsidies and other forms of domestic support for agriculture. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 36

High-Technology Export Subsidies • We now change focus from agriculture to high-technology products. • The high-tech sector also receives substantial subsides from the government. w An example being subsidies to the aircraft industries in both the U. S. and Europe. • In the U. S. , subsidies take the form of low-interest loans provided by the Export-Import Bank. w The Export-Import Bank is a U. S. government agency that finances export related projects. • Japan and South Korea give direct subsidies to high-tech manufacturing firms and reach certain targets for export sales. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 37

High-Technology Export Subsidies • One reason that some governments support hightech 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 minimizes the externality. • This is similar to the infant industry argument for tariffs, but is applied to an export instead of an import. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 38

High-Technology Export Subsidies • “Strategic” Use of High-Tech Export Subsidies w Governments argue subsidies might give a strategic advantage to export firms competing with a small number of rivals in international markets. § If extra profits are greater than the subsidy, then the exporting country has an overall gain. w We will use an assumption of imperfect competition to examine this issue. duopoly w Each firm can set the price and quantity of its output based on the price and quantity decisions of the other firm. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 39

High-Technology Export Subsidies • “Strategic” Use of High-Tech Export Subsidies w 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. w To capture strategic decision making of two firms, we will use game theory. § The modeling of strategic interactions (games) between firms as they choose actions that will maximize their returns. w The goal is to model the strategic interactions of high -tech firms in Home and Foreign, and then see the impact of export subsidies on their respective decisions and payoffs. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 40

High-Technology Export Subsidies • “Strategic” Use of High-Tech Export Subsidies w We begin with free trade. w Two firms are competing for sales of a new type of aircraft. w 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. w We will ignore sales in their own countries, so we do not have to keep track of consumer surplus. w Welfare is only dependent on the profits earned by Boeing or Airbus from sales to the rest of the world. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 41

“Strategic” Use of High-Tech Export Subsidies • Payoff Matrix w Figure 10. 5 shows a payoff matrix for Boeing and Airbus. w Each producer must decide whether or not to produce the new aircraft. w Each quadrant of the matrix shows the profit earned by Boeing in the lower-left corner. w The profits of Airbus are in the upper-right corner. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 42

“Strategic” Use of High-Tech Export Subsidies Figure 10. 5 © 2008 Worth Publishers ▪

“Strategic” Use of High-Tech Export Subsidies • Nash Equilibrium w We want to determine the outcome of this game between the two firms. w We use the concept of the Nash Equilibrium. § The action of each player is the best possible response to the action of the other player. • Best Strategy for Boeing w What are Boeing’s possible strategies if Airbus chooses to produce? w Systematically work through the matrix. w The bottom left square is a Nash Equilibrium. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 44

“Strategic” Use of High-Tech Export Subsidies • Multiple Equilibria w Is it possible to have more than one Nash Equilibrium? w What if Boeing decides to produce first. w We can then look at the top row and see that Airbus’ best strategy is to not produce. w If Airbus does not produce, looking at the last column of the matrix, Boeing’s best strategy is to produce. w Therefore, the top right-hand box, with Boeing producing and Airbus not producing, is also a Nash Equilibrium. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 45

“Strategic” Use of High-Tech Export Subsidies • Multiple Equilibria w When there are two Nash equilibria, then there must be some force that determines which one we are in. w One of these is the first mover advantage. § One firm is able to decide whether or not to produce before the other firm. w 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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 46

“Strategic” Use of High-Tech Export Subsidies • Multiple Equilibria w The European government might decide to provide subsidies to Airbus to achieve this. w What happens to the payoff matrix, if anything, in such a case? w 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. w We will present a subsidy example in the “Headlines” section next. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 47

Airbus, China and Quid Pro Quo HEADLINES • Airbus was negotiating to build an assembly line for a new passenger plane in China. • The deal would have a significant effect on its business dealings there. • Producing European planes in China would give Airbus an advantage in the battle with Boeing for the world’s next great aviation market. • Airbus has 344 planes in service in China, Hong Kong, and Macao, but Boeing still dominates with nearly 2/3 of the market. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 48

Airbus, China and Quid Pro Quo HEADLINES • Airbus’ move shows the lengths it is willing to go to break into China’s market, despite being active there since 1985 without success. • Boeing has no plans to build a production line in China, but has still won orders to supply many of its 737 s to Chinese carriers. • Airbus could greatly aid Europe in cultivating commercial ties with China. • Chinese and French leaders celebrate visits to each other with the signing of aircraft deals. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 49

“Strategic” Use of High-Tech Export Subsidies • Effect of a Subsidy to Airbus w Suppose the European governments provide a subsidy of $25 million to Airbus to produce. w This increases Airbus’ profits by $25 million when it produces. • Best Strategy for Airbus and Boeing w In fact, Airbus is better off producing, now matter what Boeing does. w Boeing recognizes this and stays out of the market. w The bottom left corner is the only Nash equilibrium. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 50

“Strategic” Use of High-Tech Export Subsidies Figure 10. 6 © 2008 Worth Publishers ▪

“Strategic” Use of High-Tech Export Subsidies • European Welfare w The subsidy has a big impact on the equilibrium of the game, but is Europe better off? w Since Europe is producing for the rest of the world, there is no consumer surplus in Europe. w Airbus’ profits have increased from $0 to $125 million. w The revenue cost of the subsidy is $25 million. w The net gain in European welfare is +$100 million. § The increase in profits are greater than the cost of the subsidy. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 52

Subsidy with Cost Advantage for Boeing • What about cost differences? w Let us now consider another case in which Boeing has a cost advantage over Airbus. w Assume the advantage is not from a subsidy, but due to U. S. comparative advantage in aircraft production. w This gives another payoff matrix in figure 10. 7. w Boeing earns profits of $5 million when both firms produce, and profits of $125 million when Airbus does not produce. w The only Nash equilibrium—the upper right quadrant— is where Boeing produces and Airbus does not. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 53

Subsidy with Cost Advantage for Boeing Figure 10. 7 © 2008 Worth Publishers ▪

Subsidy with Cost Advantage for Boeing • Can we have both? w Now suppose the European government provides the $25 million subsidy to Airbus but Boeing still has the cost advantage. w 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. w Best Strategy for Boeing § Given that Airbus produces, Boeing earns profits of $5 million when it produces and $0 when it does not. w Therefore, Boeing will stay in the market. Both firms producing is now the new Nash equilibrium. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 55

Subsidy with Cost Advantage for Boeing Figure 10. 8 © 2008 Worth Publishers ▪

Subsidy with Cost Advantage for Boeing • European Welfare Once Again w When Boeing has the cost advantage, the European subsidy allows Airbus to enter the market. w This has not resulted in the exit of Boeing as it did in the earlier no-cost-advantage scenario. w Airbus’ profits have increased from $0 to $20 million. w The revenue cost of the subsidy to Europe is still $25 million. w The net gain in European welfare is now -$5 million. w When Boeing has the cost advantage, the subsidy leads to a net loss in European welfare. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 57

Subsidy with Cost Advantage for Boeing • Summary w Under conditions of imperfect competition, a subsidy by one government to its exporting firm might increase welfare for its nation or it might not. w There is an increase in welfare only if profits rise by more than the cost of the subsidy. w This is more likely satisfied if the subsidy leads to the exit of the other firm. w 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. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 58

Subsidies to Commercial Aircraft APPLICATION • The U. S. and Europe have used various types of subsidies to support their respective firms: 1. Indirect subsidies that arise because the R&D for military versions effectively subsidize R&D for civilian aircraft. 2. The government might directly subsidize the R&D costs of a new aircraft, as Europe subsidizes R&D at Airbus. 3. The government can subsidize the interest rates that aircraft buyers pay when they borrow money to purchase aircrafts. § Europe and the U. S. both provide low interest loans to aircraft purchasers. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 59

Subsidies to Commercial Aircraft APPLICATION • 1992 Agreement w Development subsidies are now limited to 33% of the total development costs of a new aircraft. w Limits indirect (military) subsidies to not more than 4% of any firm’s annual sales. w Prohibits production subsidies. w Limits the ability of government agencies to subsidize the interest rate on purchases of aircrafts. • Reducing subsidies led to a rise in prices for aircraft by 3. 1% and 8. 8%. w Governments benefit from not having to pay the subsidies. w Higher prices help firms but hurt importing countries. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 60

Subsidies to Commercial Aircraft APPLICATION • The Super Jumbo w There are claims that the terms of the agreement are being violated by Airbus. w It is selling a new aircraft, the double-decker A 380, which is larger than the Boeing 747 and competes directly with it. w The expenditures to develop the A 380 are estimated at $12 billion. w The European governments provided about $3. 5 billion in low-interest loans to cover development costs. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 61

Subsidies to Commercial Aircraft APPLICATION • The Super Jumbo w 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. w Europe was accused of “illegally” subsidizing the A 380, while the U. S. was accused of subsidizing the development of Boeing’s 787 commercial jet. w The complaints charged that these subsidies violate the 1992 agreement. § The U. S. is calling for termination of the agreement. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 62

Subsidies to Commercial Aircraft APPLICATION • National Welfare w Will the subsidies to Airbus increase national welfare? w From the previous information, it is more likely to happen if Airbus is the only firm producing in that market. w Boeing has announced it will not produce a doubledecker like the A 380. w It will instead modify its current 747 and focus R&D on its new 787 “Dreamliner” aircraft. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 63

Subsidies to Commercial Aircraft APPLICATION • National Welfare w 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. w The profits earned will depend on how many are sold and at what price. w 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. w As of April 2006, it has orders for only 159 and many of those has been discounted at least 10%. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 64

Subsidies to Commercial Aircraft APPLICATION • National Welfare w In mid-June 2006, Airbus told its buyers it could not deliver as promised—delays of 6 months or more. w Several of the largest customers entered into discussions to seek compensations for the delay. w Singapore Airlines announced it would order the Boeing 787 “Dreamliner” instead. w The stock price of Airbus’ parent company, EADS, fell by more than one-quarter of its value in a single day. © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 65

Subsidies to Commercial Aircraft APPLICATION • These events do not mean the Airbus A 380 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 © 2008 Worth Publishers ▪ International Economics ▪ Feenstra/Taylor 66