evren güldoğan- a theoretical framework for evaluating the state aid policy of the european union
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The paper version of my MA thesis presented at ICBEM 2007.TRANSCRIPT
1
A THEORETICAL FRAMEWORK FOR EVALUATING THE STATE AID POLICY OF THE EUROPEAN UNION
*
Evren Güldoğan 183. Sokak 14/3 35280 Hatay/ĐZMĐR
Abstract
Governments intervene to markets because of conventional reasons such as market
failures, intergovernmental competition and political economic considerations.
Subsidies, which are among the tools of such intervention, can be distortive in the context
of international trade. European Union regulates the use of subsidies by its
supranational State aid policy that strikes a balance between distortions of competition
and benefits. In order to evaluate this policy ̶ which has attracted little academic
interest ̶ a basic strategic trade policy model with a Cournot duopoly is utilized. The
Commission that executes the policy is assumed to be a legal compliance maximizing
agency that carries out a cost-benefit analysis. The question of externalities and ̶ using
a simplified Grossman-Helpman framework ̶ political economic considerations are also
taken into account in order to cover the unintended consequences of the policy.
Key words: Government intervention to markets, subsidies, European Union, State aid
policy.
JEL Classification: F12, F 13, F 15, F53, L 59
1. INTRODUCTION
Economics provides the essential background for competition law and policy (CLP). The
adoption of primary provisions protecting competition such as the Sherman and Clayton
Acts in the United States of America and Articles 81 to 89 of the Treaty establishing the
European Community (the Treaty) in the European Union1 (EU) actually represents a
* This article draws on the author’s thesis submitted in partial fulfillment of the requirements for
the MA degree at the European Community Institute of Marmara University in 2005. The author
is grateful to Fatma Doğruel from Marmara University who supervised the thesis work. 1 It has become the conventional practice to use the name European Union instead of legally
proper European Community in non-legal scholarship.
2
concern about business dynamics instead of a taste of economic theory on behalf of
legislators. However competition authorities and other practitioners in the field
frequently refer to economic models and utilize empirical economic techniques while
handling cases in practice. This economic approach to matters of competition has only
been strengthened in recent years, most notably as a result of merger control reform in the
EU (Christiansen, 2006).
However the State aid (SA) policy of the EU has received little attention in the economics
literature (Collie, 2005: 1), at least in comparison to other issues related with CLP. One
obvious reason behind this state of affairs is that the SA policy is a branch of competition
law specific to the EU. While there are a number of international regimes that control
subsidies, the most important of which is the World Trade Organization disciplines, there
exists no other supranational jurisdiction other than the EU where subsidies become a
matter of CLP instead of trade policy. Another reason might be that the economic
analysis of the SA policy seems pretty straightforward: A supranational policy, that
overcomes the collective action problem in prohibiting government subsidies distorting
competition and therefore causing deadweight losses, is beneficial for social welfare.
There is more than that meets the eye, of course.
European Commission has commissioned or carried out a number of studies since late
1990s in order to remedy the state of affairs in question. These studies that cover both
theoretical and policy-oriented grounds have also sparkled a number of independent
efforts and significantly contributed to the understanding of the SA policy2.
Nevertheless a model that enables a comprehensive evaluation of the policy has not been
offered yet. This article intends to make a modest theoretical contribution to close this
gap in the literature. With this purpose in mind, the substance of the SA policy is briefly
examined in conjunction with different reasons of government intervention in the markets
in the following section. In section three previous studies of relevance are reviewed. In
section four a model that unifies and generalizes their findings is built by a gradual
approach. The final section concludes.
2. GOVERNMENT INTERVENTION IN THE MARKETS AND THE STATE
AID POLICY
Under the first paragraph of Article 87 of the Treaty that lays down the essence of the SA
policy, a measure which (1) is an aid (2) granted by a Member State (MS) or through its
resources, that (3) distorts or threatens to distort competition by favouring certain
2 Friederiszick, Röller and Verouden (2006) provide a review of the present state of the resulting
knowledge as well as its impact on the application of the policy.
3
undertakings or the production of certain goods3 and (4) affects intra-Community trade is
deemed as a SA. SAs are incompatible with the common market and therefore
prohibited4.
The inclusion of a discipline for subsidies in the Treaty was strictly necessary since they
could have easily replaced tariffs and equivalent measures5 and eliminate the benefits
associated with market integration. However as it can be seen Article 87 does not
prohibit all subsidies, but only a certain subset of them which it delineates. In other
words the Treaty acknowledges that certain measures taken by governments that distort
competition have legitimate rationales. That takes one to consider reasons of government
intervention in the markets in the first place. Indeed Harden (1990) states that a
satisfactory definition for SAs “could be offered only as a part of a broader conceptual
framework for answering the central question of political economy: what is the proper
relationship between the modern state and the market?”.
From the perspective of economic theory the primary rationale for government
intervention in the markets is the insufficiency of the market mechanism to ensure
allocative efficiency. Such insufficiency might arise from prohibitive transaction costs,
coordination failures or market failures6. Governmental paternalism, economized in the
public finance literature through the constructs of tradeoff between equity and efficiency
and merit goods, is another major rationale. Since the validity of both rationales are
generally accepted, at least with a varying degree of tolerance, by academics and
practitioners alike it is safe to describe the underlying reasons of government intervention
as conventional. Indeed, as illustrated by Meiklejohn (1999), the Commission’s
conception and practice of the SA policy have such a conventional focus.
Conventional reasons explain government intervention without taking into consideration
the existence of foreign governments. However the SA policy wouldn’t have existed if
the world consisted of a single closed economy. Multiplicity of governments leads to
further grounds for intervention because of the phenomenon of intergovernmental
3 General measures that do not favour particular undertakings or goods are thus out of the scope of
Article 87. In other words there is no recourse to the SA policy against competitive devaluations
and more relevantly harmful tax competition. 4 The SA policy has been the subject of a large body of case law by the Court of Justice of
European Communities that elaborated, besides other issues, on the definition of a SA especially
with regard to services of general economic interest. Quigley and Collins (2003) and Biondi,
Eeckhout and Flynn (2004) provide complementary treatises of legal aspects of the SA policy. 5 In theory the exact impact of a tariff can also be obtained by a combination of consumption taxes
and production subsidies. 6 Market failures are caused by non-excludable goods, externalities, informational failures and
strategic behaviour by market actors.
4
competition that primarily takes two forms: strategic trade policy (STP) and tax
competition.
STP is a modern mercantilist theory stemming from two articles by Spencer and Brander
(1983, 1985) which argues that in oligopolistic international markets, governments can
shift profits from foreign producers to domestic players through intervention. In this case
the optimal strategic policy is a subsidy7; however if reciprocity is allowed for, the
subsidy-ridden international equilibrium, called as a subsidy war, is jointly sub-optimal.
While the EU does not shy from pursuing such an industrial policy in international
markets, profit shifting through subsidization is strictly prohibited within its common
market by means of Article 87.
Tax competition, a phenomenon conceived differently from theoretical and policy-
oriented perspectives, is another story. Tiebout (1956) tradition in public finance
emphasizes the functionality of competition, an inherent aspect of fiscal federalism, in
sorting people and enterprises according to their heterogeneous preferences for local
public goods and corresponding tax rates and thus achievement of Pareto-efficient results.
However the picture is blurred when the question of optimal taxation is left aside. The
trend toward decrease of tax rates associated with the current phase of globalization has
created two camps in policy-oriented literature. On the one hand Oates (1972) and
Zodrow and Mieszkowski (1986) serve as the origin of studies arguing that tax
competition creates a race-to-the-bottom that erodes state sovereignty and weakens public
good provision and redistribution. On the other hand there are those who believe that tax
competition creates economic efficiency and therefore spurs economic growth (Edwards
and de Rugy, 2002) particularly by taming the Leviathan (Brennan and Buchanan, 1980).
Conflicting views also reflect to actual policy: EU has neither achieved satisfactory
progress in the harmonization of direct taxes nor can utilize SA policy against general tax
measure.
A third source of government intervention in the markets besides conventional reasons
and intergovernmental competition is political economy. It is possible to distinguish
between two non-mutually exclusive understandings of political economy: application of
economic models to political phenomena and the study of interaction between economics
and politics. Saint-Paul (2000: 915) characterizes economists’ contributions to this field
of multidisciplinary interest as follows:
“First, it chiefly aims at explaining actual economic policies, rather than taking it as
exogenous, as do ‘conventional economics.’ Second, it departs from the assumption often
made in conventional economics that policy is determined by maximizing a social welfare
7 Brander and Spencer’s results hold under Cournot competition. Eaton and Grossman (1986)
showed that under Bertrand competition the optimal strategic policy is an export tax.
5
function. It explicitly takes into consideration that policy is determined by a political
mechanism and therefore will reflect the interests of the most powerful groups in society.”
Political economy literature takes into account the possibility that private interest holders
can lobby governments in order to influence policy outcomes. Such directly
unproductive profit-seeking activities are costly for the society; because (1) lobbying
requires resources that can otherwise be utilized for productive purposes and (2) the
resulting policy creates distortions that decrease social welfare (Winters, 1991: 160-169).
The Grossman-Helpman (1994) model has dominated the study of these wasteful interest
group activities, at least in the context of trade policy.
It is clear that under the SA policy only conventional reasons of government intervention
are likely to be tolerated. Indeed after prohibiting SA in the first paragraph, Article 87 is
quick to provide exceptions. According to the second paragraph if a SA (1) has a social
character and granted to individual consumers without any conditions on the origin of the
products concerned, (2) is granted to make good the damage caused by natural disasters
or exceptional occurrences or (3) to certain areas of Germany adversely affected by the
division of the country in so far as such aid is required for compensation of the damage, it
should be allowed. The third paragraph further states that the following categories of SA
may also be permitted: (1) aid to promote development of underdeveloped areas or areas
with serious underemployment, (2) aid to promote the execution of an important project
of common European interest or to remedy a serious disturbance in a MS, (3) aid to
facilitate the development of certain economic activities or of certain economic areas
without contradicting the common interests of the MSs, (4) aid to promote culture and
heritage conservation without affecting trading conditions and (5) other categories of aids
that may be specified by the Council of Ministers on a proposal from the Commission8.
Despite somewhat being versed in ambiguity and obliqueness that so define diplomatic
discourse (Villar, 2005) the above provisions effectively exempt most paternalistic and
corrective subsidies in so far as they are called for and moreover allows for subsidies
ridden by motivations of STP or political economy at the European level. Yet Article 87
is silent about government intervention for the sake of these unconventional reasons
within the common market9.
However, as often encountered in Weberian ideal typical analysis (Weber, 1978),
subsidization in practice involves an overlap or interaction of categories of its reasons as
laid down in this article. Therefore in order to evaluate the welfare impact of the SA
policy comprehensively, a model that takes into consideration all three reasons of
8 Note that while SAs that fall into the scope of the second paragraph of Article 87 should be
allowed, those covered by the third paragraph might be allowed. 9 Baldwin and Wyplosz (2004: 163) imply that the inclusion of Article 87 in the Treaty was
actually a reflection of concerns about such government intervention.
6
government intervention in the markets and emphasizes the associated unintended or
unanticipated consequences (Merton, 1936) is required. For that purpose a review of
previous studies of relevance is necessary. This is the task of the following section.
3. TOWARDS A COMPREHENSIVE EVALUATION OF THE STATE AID
POLICY
Legal scholarship on the SA policy is extensive and there exists a burgeoning political
science literature on the subject. However, leaving aside methodological studies and
policy reviews commissioned by the European Commission, economic treatments of the
SA policy are scarce10
.
In their seminal article on the subject Besley and Seabright (1999) criticize the
application of the SA policy by means of a benchmark model that draws insights from the
three theoretical frameworks they find suitable for the evaluation of the SA policy,
namely STP, the Tiebout tradition in public finance and new economic geography. The
menu auction model where two governments compete to affect investment decisions of
firms allows for locational externalities and basically demonstrates that (1) the SA policy
should take into account the possible impact of subsidies on the optimal allocation of
geographical activity within the common market and (2) that intergovernmental
competition might be beneficial. However this focus on locational externalities limits the
generalizability of Besley and Seabright’s findings.
A second study by Seabright, this time with Dewatripont (2006), presents more general
results. The authors take into consideration the domestic impacts of the SA policy and
justify the argument that supranational control of subsidies is beneficial for curbing
wasteful spending by national governments.
Collie builds a STP model with a symmetric Cournot oligopoly (2000) and extends it by
addition of Bertand competition and differentiated products (2002a), foreign (vs. intra-
Community) trade (2002b) and investment and R&D subsidies instead of production
subsidies (2005) in order to demonstrate the conditions under which subsidies should be
prohibited. However some of findings of the author are non-results as his grasp of the
policy is insufficient. For instance the argument that if products are sufficiently
differentiated prohibition of subsidies would not be beneficial (Collie, 2002a) is irrelevant
10
Econometric studies on the determinants of government subsidies (Clement, Hugounenq and
Schwarts, 1995; Zahariadis, 1997; Clement, Rodriguez and Schwarts, 1998; Neven and Röller,
2000) are not taken into consideration since they do not specifically address the SA policy, even
when the authors – from the perspective of EU law, erroneously – prefer the term “State aid”
instead of subsidy.
7
since such products would not be included in the same relevant product market by the
European Commission. As a result the most important contribution of Collie to the
understanding of the SA policy is his modeling of investment and R&D subsidies instead
of production subsidies as the latter are not permitted under the SA policy most of the
time.
Møllgaard (2005), who believes that much of subsidies do not directly affect marginal
costs, also examines the question of investment in network industries where investments
that enhance demand are important. His complicated model results in the creation of a
dominant position and even predation by the aid recipient enterprise. Even though his
argument on marginal costs is not convincing Møllgaard is right in drawing attention to
market structure and its consequences.
Indeed Garcia and Neven (2005) model how different market characteristics, in particular
concentration and substitution, affect the distortion of competition caused by subsidies.
The authors correctly interpret Article 87 and define distortion as the effect on the profits
of rival enterprise instead of collective waste11
. However they take into consideration
production subsidies.
Glowicka (2005) studies rescue & restructuring (R&R) subsidies instead by means of a
STP model with asymmetric Cournot competition. As the author states R&R subsidies
are particularly prone to distort competition since they are given to otherwise exiting
firms; but she also demonstrates that the welfare impact is dependent on the initial cost
differences and the size of the subsidizing country.
As it can be seen the economic treatment of the SA policy, despite its scarcity, has
uncovered important unintended consequences. First of all, while Article 87 is designed
to prohibit distortion of competition as defined by Garcia and Neven (2005) the practice
of the SA policy goes further and prevents collectively or unilaterally wasteful
subsidization as respectively demonstrated by STP (Collie 2000, 2005) and political
economy models (Dewatripont and Seabright, 2006). Second, the impact of SAs and
therefore their prohibition depend on the characteristics of the relevant market
(Møllgaard, 2005; Garcia and Neven, 2005). Third, under certain circumstances SAs can
be beneficial for social welfare (Besley and Seabright, 1999; Glowicka, 2005). The first
unintended consequence provides a suitable background for the unification and
11
Rainer and Heidhues (2006: 5-6) state that the SA policy should move from this focus on effect
on rivals to a social welfare standard following the practice in other branches of EU CLP.
However they seem to equate consumer surplus with aggregate welfare which is not true. See
Neven and Röller (2005) for a study on the difference between the adoption of these alternative
standards in a merger control setting.
8
generalization of the results for the sake of obtaining a more comprehensive evaluation of
the SA policy. Such a model is presented in section four.
4. THE MODEL
4.1. STP in a Common Market
Following Collie (2005) and Glowicka (2005) a STP model is preferred. There are two
types of STP models, consideration of consumer surplus being the distinguishing feature:
third-market models and reciprocal market models. In the former type competing
countries export the supported goods to a third market. Therefore there is no need to take
into consideration consumer surplus. In third-market models the domestic government
cannot do anything to hinder the production of the competing country and only the
strategic effects of the policies are observed. In reciprocal market models there is
domestic consumption of the goods produced by the supported industry; so consumer
surplus is taken into consideration. One of the main characteristics of these models is
market segmentation (Brander, 1995: 7-11). In applications to the EU, market
segmentation does not exist (as in Glowicka) or has no impact (as in Collie). For
simplicity a third-market model is u below; but consumer surplus is also discussed to
show the underlying mechanism of exchange.
Assume the following story: Three identical countries (A, B, C) form a common market;
so all barriers to trade are eliminated between the parties. A symmetric Cournot duopoly
(firms i, j) that produces a homogenous good under perfect information operates in this
setting. Firm i is located in A and firm j is located in B. Both firms export their entire
output, qi and qj, to C. There is no consumption of this homogenous good in A or B.
There is a single factor of production in all three countries: labor. The entire population
works. In A and B labor can be used to produce either the homogenous good by the
Cournot duopolists or a numeraire good12
. Numeraire good is produced with constant
returns to scale under perfect competition. One unit of labor produces one unit of either
good. Labor is paid its marginal product. Therefore no profits arise from the production
of the numeraire good and there is no income difference for labor between the sectors13
.
Labor can move freely among them. Consumers in A and B only consume the numeraire
12
A numeraire good is a good whose world and domestic prices are equal and normalized to one.
It absorbs all income effects and therefore is a standard feature of international trade models. 13
Note that profits arise from the production of homogenous good because of imperfect
competition.
9
good. It is imported from C in exchange for the homogenous good by what is called
“behind-the scenes” trade14
.
The profit of the firm i is determined by the demand function, cost structure and
Cournot’s conjunctions, i.e. setting output for profit maximization in knowledge of the
fact that other party behaves the same. The demand function is linear. The inverse
demand function is:
p = a – bQ = a – b (qi + qj) (1)
Fixed costs do not exist; so the production costs consist of marginal costs only. Since
there is symmetry between the firms they face equivalent marginal cost curves. There are
constant returns to scale. Therefore marginal cost curves are linear:
C(qi) = cqi (2)
Under these conditions profit of firm i is:
πi = [a – b (qi + qj)] qi – cqi (3)
The first order condition (FOC) is:
∂πi/∂qi = – bqi + a – b (qi + qj) – c = 0 (4)
Therefore output of firm i equals
22
j
i
q
b
caq −
−= (5)
while that of firm j equals 22
i
j
q
b
caq −
−= .
By simple substitution the solution of the system of these two outputs yields the
following:
b
caqq ji
3
−== (6)
14
The focus is on the first elements of the symmetric pairs, country A and firm i respectively, in
the discussion below.
10
Total output equals to b
ca
32
−. This is a Cournot-Nash equilibrium.
In the Cournot duopoly the outputs of the firms are strategic substitutes. If the output of
one firm increase that of the other would decrease. Since the profits are functions of
outputs they are also affected. This can be demonstrated formally by using second partial
derivatives. In the case of firm i: 02
⟨∂∂
∂
jqiq
iπ. The profit of firm i decreases if the output
of firm j increases. Therefore the Cournot duopolists have incentive take market share
from each other; but they cannot do that because of cost symmetry.
Under cost asymmetry the results are different. In other words if one of the firms can cut
down its costs, it can raise its market share. Assume that firm i decides to cut down its
costs, c, by a margin. In order to do so it needs to make investment. Firms can undertake
investment strategically or non-strategically depending on the timing of the investment
and output decisions (Collie, 2005: 3-4). The non-strategic case is simpler; but the
strategic case is more realistic and widespread in use. Behaving strategically firm i first
makes the investment decision and then both firms make their output decisions. That is a
two-stage game.
Modifying Collie (2005) cost reduction equals to c – θxi where xi is investment of firm i
and θ shows the magnitude of cost reduction created by the investment. The cost of
investment is quadratic: 2
2ix
σ. Following this cost-reducing investment the profit
function of firm i becomes:
πi = [a – b (qi + qj)]qi – (c – θxi)qi – 2
2ix
σ (7)
The FOC for qi is as follows:
∂πi/∂qi = – bqi + a – b (qi + qj) – c + θxi = 0 (8)
So qi is:
b
xcbqaq
ij
i2
θ+−−= (9)
11
The FOC for qj does not change: 22
i
j
q
b
caq −
−= . By substitution the system of these
two outputs is solved to obtain the following:
b
xcaq i
i3
2θ+−= (10)
b
xcaq i
j3
θ−−= (11)
It is clear that investment xi increases the output of firm i and decreases that of firm j.
Therefore cost-reducing investment and output in a firm are strategic complements.
In order to see the effect of the increase of xi on pi and pj formally, the partial derivates of
these production functions should be taken with respect to xi. These operations give the
following results:
∂qi/∂xi = 03
2⟩
b
θ (12)
∂qj/∂xi = 03
⟨−
b
θ (13)
After solving the output stage (second stage) of the game it is turn for the investment
stage (first stage). Since there is perfect information firm i anticipates its output decision
while making the investment decision. Therefore rearranging (9) to obtain 2bqi and
substituting this to (7) one can get the following profit function for the first stage:
πi = 2
ibq – 2
2ix
σ (14)
Since qi is obtained using xi as shown in (10) the FOC of xi includes a partial derivative
of qi with respect to xi:
∂πi/∂xi = 2bqi(∂qi/∂xi) – σxi = 0 (15)
Substituting from (9) and (12) and arranging, xi equals to:
12
xi = 289
)(4
θσ
θ
−
−
b
ca (16)
It is implicitly assumed that firm j cannot make such cost-reducing investment. If that
assumption is lifted and symmetry is thus re-introduced then both firms would make the
same level of investment. In that case investment would not have an impact on market
shares. This is where STP enters the game. A government can shift profits to a resident
firm from its rival by subsidizing the former’s investments.
Denote the labor endowment of country A as P that stands for population. Assuming that
the profits of firm i are distributed among the laborers the domestic welfare (W) of A is
the following:
W = P + πi (17)
Country A has a government (G). Being a benevolent government, i.e. a government
whose objective function is identical to the domestic welfare function of the country, G
gives an investment subsidy (S) to firm i15
. Since P is a fixed endowment that can be
ignored in the mathematical analysis, under STP domestic welfare of A becomes:
W = πi – S (18)
(18) implies that if S can raise πi more than its own value then it is rational for G to
subsidize. That adds a new stage to the game. In this new initial stage G makes a
decision about subsidizing firm i. It is assumed for now that firm j receives no subsidy
from its own government. Firms then first make investment choices in stage two and
then output choices in stage three; so firms make their choices under government
commitment16
.
The subsidy in question is given proportionately to the cost-reducing investment by firm
i17
:
S = si.xi (19)
15
It is assumed that the subsidy is financed by non-distortionary means. Otherwise si in (19)
below would be explicitly multiplied by a parameter, λ. Here λ is implicitly set as one. 16
The lack of government commitment complicates STP and is usually used to demonstrate that it
is inefficient as in Leahy and Neary (1996). 17
In Glowicka (2005: 4) the government first observes the market and then gives a subsidy which
is not proportional to the investment already undertaken by the firm.
13
Therefore the profit function of the firm i becomes:
πi = [a – b (qi + qj)]qi – (c – θxi)qi – 2
2ix
σ + si.xi (20)
Since firm j can also make investment now the entire game should be resolved. The FOC
for qi and the profit maximizing value of qi remains as in (8) and (9):
∂πi/∂qi = – bqi + a – b (qi + qj) – c + θxi = 0
b
xcbqaq
ij
i2
θ+−−=
However since firm j can invest now the value of qj is:
b
xcbqaq
ji
j2
θ+−−= (21)
As before by substitution the system of these two outputs is solved to obtain the
following values:
b
xxcaq
ji
i3
2 θθ −+−= (22)
b
xxcaq
ij
j3
2 θθ −+−= (23)
It is again clear that investment by one firm has a negative effect on the output of the
other. Results (12) and (13) are still valid; but now the partial derivates of the production
functions taken with respect to xj give the same results:
∂qi/∂xi = ∂qj/∂xj = 03
2⟩
b
θ (24)
∂qj/∂xi = ∂qi/∂xj = 03
⟨−
b
θ (25)
14
After solving the output stage (which is now the third stage) investment stage (now
second stage) can be solved as before. Rearranging (9) to obtain 2bqi and substituting
this now to (22) the following profit function is obtained for firm i:
πi = 2
ibq – 2
2ix
σ + ii xs (26)
The profit function for firm j is also modified by rearranging (21) and substituting. Since
this firm is not given subsidies its profit function is similar to (14):
πj = 2
jbq – 2
2jx
σ (27)
The FOCs for xi and xj are respectively given in (28) and (29):
∂πi/∂xi = 2bqi(∂qi/∂xi) – σxi + si = 0 (28)
∂πj/∂xj = 2bqj(∂qj/∂xj) – σxj = 0 (29)
Substituting from (22) and (23) and arranging xi equals:
xi = 289
9444
θσ
θθθ
−
+−−
b
bsxca ij (30)
Substituting from (24) and (25) and arranging xj equals:
xj = 289
444
θσ
θθθ
−
−−
b
xca i (31)
By comparing (30) and (31) it can be seen that (1) investment by one firm has a negative
impact on the investment of the other and (2) subsidies given by G to firm i has a
negative impact of firm j.
The solution of the above system of investments is as follows where ∆ is (9bσ 8θ2):
15
xi = 22 16
9)4)(44(
θ
θθθ
−∆
∆+−∆− ibsca (32)
xj = 22 16
36)4)(44(
θ
θθθ
−∆
+−∆− ibsca (33)
(32) and (33) give respectively the optimal values of investment for firm i and j when
they are anticipating the output decisions.
In order to determine the effect of the subsidy provided by G on the investment level the
partial derivatives of investment function should be taken with respect si. These are as
follows:
∂xi/∂si = 016
922⟩
−∆
∆
θ
b (34)
∂xj/∂si = 016
3622⟨
−∆
∆
θ
b (35)
As the investment stage (second stage) of the game is solved the first stage where G plays
can be examined now. G decides on the optimal level of the subsidy in order to
maximize its objective function which is equivalent to the domestic welfare function.
Substituting (19) to (18) domestic welfare is:
W = πi – si.xi (36)
Since the values for outputs and investment are obtained these can be substituted to the
domestic welfare function in order calculate the FOC for si:
∂W/∂si = 0 (37)
The outcome is too complicated to be reported; but there exists a value for si that
increases the profits of firm i and hence domestic welfare more than its cost (si xi). In
other words STP does work under these conditions.
However if the assumption that the government of country B does not give subsidies to
firm j were to be lifted (27), (29), (31), (33) and (35) would have to be modified. The
16
resulting symmetry would lead the second government to subsidization as well.
Therefore the governments would engage in a subsidy war. In that case subsidies would
not shift profits and be collectively wasteful at the equilibrium18
. The governments would
find themselves in a Prisoners’ Dilemma. This finding is one of the central results of
STP. It holds for all or most values in all models. Since there is symmetry in the above
model the welfare loss would be equal in A and B; so total welfare loss for the common
market would be 2S.
4.2. European Commission as a Legal Compliance Maximizer Agency
Given the welfare losses governments in A and B have incentive for co-operation; but
the structure of the game does not enable reciprocal action. One way to break out of this
Prisoners’ Dilemma is undertaking a credible pre-commitment. The MSs of the EU use
the SA policy as a device for this purpose. Credibility is assured by the means of a
principal-agent relationship formed by delegating the competence for the execution of the
policy to the European Commission.
As stated above Article 87 seeks to prohibit subsidies that have an effect on the profits of
the rivals. Therefore as an agency European Commission does not act as a social welfare
maximizer. It is asked to maximize legal compliance instead. However an observation of
the actual conduct of the SA policy shows that the Commission is not simply maximizing
compliance itself, but the benefits of compliance. The quite wide margin of discretion
enabled by Article 87 and human and financial resource constraints are the two
underlying reasons of this agency behaviour.
The provisions of Article 87 can be simplified as prohibition of trade-distorting subsidies
unless they bring commonly accepted benefits of an equivalent scale. It follows that the
Commission needs to carry out a cost-benefit analysis in order to reach a decision about
the legality of a given subsidy. Therefore the decisions of the Commission can be
characterized by:
D = 0 if | B ± ε | ≤ | C ± ε |
1 if | B ± ε | > | C ± ε |
where D stands for decision (0, 1), B for benefit and C for cost. The decision of the
Commission is either prohibiting (D = 0) or permissing (D = 1) the SA. Since the
Commission actually conducts formal cost-benefit analyses seldom it does not know the
18
However the cost-reducing effect of investments would be preserved.
(38)
17
exact costs and benefits of a SA. Instead it makes enlightened guesses about the relative
scales of costs and benefits. These guesses might not be true; therefore “± ε”.
It should be noted that the behaviour of maximization of the benefits of compliance could
be captured by assuming that ε is a decreasing function of the SA. Therefore total errors
would be reduced as the size of the subsidy increases. This is an efficient property since
those SA decisions or schemes that create the least benefits are more likely to be
erroneously prohibited. As a result MSs would have more incentive to take/design
clearly beneficial decisions/schemes. Moreover there is no trade-off between type I
(prohibiting beneficial SAs) and type II (permissing harmful SAs) errors.
The Commission is assumed to prohibit the SA when the benefits and costs are
(approximately) equal since the agency desires to decrease the total level of SA given in
the Community. This is also consistent with the behavior of maximization of the benefits
of compliance.
Referring to the STP model above the cost is given by the effect of si on πj, which is too
complicated to be reported, but obviously negative given (35). si benefits firm i and
therefore G; but these benefits are not among those commonly accepted and thus listed in
Article 87. Therefore B is zero and so is the value of D.
As it can be seen the pursuit STP in the common market leads to the prohibition of
subsidies. Moreover this behavior seems to be pretty efficient. However B might not be
always zero. In order to examine this possibility the model needs to be extended to
include externalities, one of the conventional reasons of government intervention in the
markets.
4.3. Externalities
Non-reciprocal externalities, i.e. externalities other than those on rival firms and countries
caused by strategic interaction, have not been discussed much in the STP literature19
. A
simple, but original formulation of the question is presented here.
Assume that the production of the duopoly good by firm i creates a non-pecuniary
production externality in A without any cross-border spill-overs. Since it is non-
pecuniary the externality enters the domestic welfare function of the country A that
becomes:
19
The field of environmental economics, where the relationship between strategic environmental
and trade policies has been discussed widely since Conrad (1993), provides an exception as it does
in a number of other issues.
18
W = P + πi + E (39)
where E stands for externality. The welfare effect of externality is equally distributed
among the consumers. There is no externality generation in B.
Further assume that the externality is linearly associated with the output of firm i. One
unit of externality is created by one unit of the duopoly good produced. The externality
function is as follows:
E = eiqi (40)
In practice it is difficult to calculate precisely the welfare impact of an externality and
therefore design optimal policies for internalization. However the simplicity of the model
allows us to do so with two more assumptions, namely (1) the assumption that the value
of the externality is equal to that of the numeraire good and (2) the assumption that the
externality can be internalized by another production process that has the same
characteristics with those of the numeraire good20
.
First take into consideration a negative externality. Firm i produces qi of the duopoly
good and therefore eiqi of the negative externality that can, for example, be emission.
There are two methods of internalizing this externality: internalization through another
production process (in the case of emission an abatement sector) and internalization
through government intervention.
Take into consideration the latter option first. Governments can intervene in a number of
ways. The most efficient one is to use a Pigovian tax (subsidy) internalizing the negative
(positive) externality21
. G can alter the profit function of firm i by imposing a tax t on qi:
πi = [a – b (qi + qj)] qi – cqi – t eiqi.
That would reduce output and therefore the negative externality. However it would also
reduce total domestic welfare; because labor has the same productivity in the production
of numeraire good, that of the duopoly good and the internalization of the negative
externality. Nevertheless the duopoly good is not produced under perfect competition
that characterized the other sectors and therefore qi is charged more than its marginal
cost. Therefore one unit of the production of the duopoly good has a value greater than
20
In fact the last assumption can be omitted from the analysis; but it facilitates the conceptional
dimension of the modeling exercise. 21
This is of course a simplification. In certain cases other instruments such as emissions trading
or two-part instruments should be used.
19
one unit of internalization of the negative externality; so G, being a benevolent
government, does not tax the production of the duopoly good.
As a result the society in A has to live with eiqi or internalize it through the “abatement
sector” (or any point on the continuum between these two extremes). In all cases the
welfare loss is the same and can be quantified with respect to P, the labor endowment of
A. Given that one unit of externality is created per one unit of the good produced, one
unit of labor produces one unit of the duopoly good (Note that the model is static.) and
labor has same productivity in the production of the duopoly good and the internalization
of the externality, if the proportion of P working for firm i is λ then the welfare loss
associated with the externality is given by λP. Therefore the domestic welfare function
becomes:
W = P + πi – λP = (1 – λ)P + πi (41)
Since one unit of labor produces one unit of the duopoly good, the numerical value of λ is
straightforward22
:
λ = P
qi (42)
Next consider a positive externality. The story is very similar to that of negative
externality: Firm i produces qi of the duopoly good and therefore eiqi of the positive
externality that can, for example, be a locational externality. As assumed the unit value
of this externality and that of the numeraire good are equal to each other and the same
externality can be obtained through another production process that has the same
characteristics with those of the numeraire good. Therefore the social welfare gain
associated with the externality is given by λP. The domestic welfare function is:
W = P + πi + λP = (1 + λ)P + πi (43)
The optimal policy for internalizing this externality is increasing qi. Assuming that qi can
be increased without any costs the maximizing numerical value of qi would be P, i.e. the
entire population in A would work form firm i23
. Then domestic welfare would become
2P + πi instead of P + πi, the case without a positive production externality.
22
So why is λ used at all? The reason is that otherwise the numerical value of qi might be mixed
with the market price of the qi amount of the duopoly good as the domestic welfare function would
be reduced to P + πi qi. 23
Assume that entry to the numeraire good market is free; therefore firm i cannot benefit from
being a monopsonist in the labor market through bidding wages down.
20
What are the implications of externalities under STP? In the case of the negative
externality, increasing the output of firm i would also increase proportionately the amount
of the negative externality generated. Therefore the profit obtained by an additional unit
of output should not only be greater than the subsidy given for this purpose, but the sum
of the corresponding subsidy and the negative externality generated; so if the profit
margin is not wide enough the optimal subsidy would be zero (but not negative). In
general:
∂W/∂si > ∂WN/∂si (44)
where subscript N stands for negative externality.
In the context of the SA policy of the EU, the Commission would prohibit any subsidies
under these conditions. Note that from the Commission’s viewpoint the existence of the
negative externality has not changed the analysis. However if the subsidy had a cross-
border spill-over then the prohibition would also prevent the resulting additional welfare
loss on B (and possibly third countries) as an unintended consequence.
Therefore the case of a positive externality is more interesting; because the existence of a
positive externality makes the subsidy more beneficial. In general:
∂W/∂si < ∂WP/∂si (45)
where subscript P stands for negative externality.
Indeed the subsidy would be beneficial even if there were no profit-shifting effects as
long as the value of the positive externality generated by one additional unit of output is
greater than the subsidy given for this purpose. Therefore from a domestic welfare
perspective the existence of positive externalities legitimizes subsidization under perfect
competition or under symmetric STP, in other words even when there is a subsidy war.
Under these conditions the cost of subsidization is the impact of si on πj and the benefit is
the impact of si on E from the perspective of the European Commission. The agency
omits from its analysis the impact of the subsidy on πi.
First take into consideration C. The impact of si on πj is too complicated to be reported as
stated before. However since the aim is showing the impact of externalities on the model
now, it is appropriate to simplify by assuming that firm j refuses to make investment (and
therefore the government of B cannot subsidize even at si = 1.).
Re-solving with this assumption yields manageable figures. Since firm j does not invest,
the solution of the system of output functions remains as in (10) and (11):
21
b
xcaq i
i3
2θ+−=
b
xcaq i
j3
θ−−=
Therefore the effect of the increase of xi on pi and pj given by (12) and (13) does not
change either:
∂qi/∂xi = 03
2⟩
b
θ
∂qj/∂xi = 03
⟨−
b
θ
The profit function of firm i stays as in (26) while that of firm j changes:
πi = 2
ibq – 2
2ix
σ + ii xs (46)
The FOC for xi is given by:
∂πi/∂xi = 2bqi(∂qi/∂xi) – σxi + si = 0 (47)
Substituting from (10) and (12) and rearranging:
xi = 289
944
θσ
θθ
−
+−
b
bsca i (48)
Since there is no investment by firm j there is no system of investment functions to solve.
The effect of si on xi becomes:
∂xi/∂si = 09⟩
∆
b (49)
Since the profit of firm j, which equals domestic welfare of B, is
πj = [a – b (qi + qj)] qj – cqj
22
after substituting, arranging and taking the partial derivative with respect to si it is
possible to see the effect of si on the profits of firm j (which is still complicated):
∂xj/∂si = 05424246
2
22
⟨∆
+−+∆− iscaa θθθ (50)
After finding out C it is turn for B, which is the impact of si on E. E equals eiqi. Since ei
is numeraire the value for E is simply qi. The same result can be reached through (41).
Since λ is equal to P
qi λP is in fact qi.
Therefore in order to find the impact of si on E, the impact of si on qi should be
determined first. That can be done by substituting the value of xi (48) in the equation for
qi (10), solving and taking the partial derivative with respect to si:
∂qi/∂si = 03
27⟩
∆ (51)
Given (50) and (51), that is C and B, Commission would make its decision after doing the
below calculation
| ∆3
27 | |
2
22 5424246
∆
+−+∆− iscaa θθθ |
with an error margin of 2ε. If the outcome is positive D = 0, if the outcome is negative D
= 1.
4.4. Political Economy
Until now it is assumed that G is a benevolent government, i.e. a social welfare
maximizer. However when governments have political economic considerations they are
unlikely to be purely benevolent. In other words their objective functions are not likely to
be identical to the domestic welfare functions of the countries they govern. According to
the Grossman-Helpman (1994) model that has dominated the study of these wasteful
interest group activities, governments are semi-benevolent and therefore maximize a
weighted sum of domestic welfare and contributions given to them by special interest
groups. A simplified version (Acemoglu, 2003: 47-54) of the model is used below to
examine political economy of the SA policy.
23
It is assumed that the profits of firm i are distributed among the laborers above. Assume
instead that χ of the P owns the firm. Further assume that they have overcome the
collective action problem and organized without any costs. This fraction of the
population forms a special interest group.
In this setting any subsidy given to firm i is a transfer from the rest of the P to this special
interest group. If there are positive externalities associated with the production of firm i,
these subsidies might still benefit the rest of the population. Otherwise they are faced
with a loss.
The decision on subsidization is made by the government, G, that does not have any
electoral concerns24
. G maximizes the objective function
G = βW + (1 β)L (52)
where L stands for lobbying contributions received by G and β, with 0 < β < 1, is a
parameter measuring the relative importance of domestic welfare and contributions for G.
If β is zero G acts as a pure rent-seeker. If β is 1 it is a purely benevolent government as
assumed in the previous sub-sections; but β is not defined for these values.
Special interest group χ offers the following binding contribution schedule L to G:
L = lisi (53)
where 0 < li < 1.
Therefore the amount of the contribution G will get is linearly associated with the amount
of subsidy χ will receive. In fact χ pays back some of the money it receives25
.
Since firm i receives subsidy per unit of investment this contribution function enters the
profit function as lisixi and so the function becomes:
πi = [a – b (qi + qj)]qi – (c – θxi)qi – 2
2ix
σ + si.xi lisixi
24
Other studies on the political economy of trade policy focus on the electoral process instead of
interest group activities. Pioneered by Mayer (1984) these somewhat naïve examinations share the
assumption that the policy is determined by majority voting among the population. In that case the
preference of the median voter prevails. If the decision on subsidization was made as in Mayer
(1984) in the above model then no subsidy would be given as long as χ < 0.5. 25
An underlying assumption is that G cannot take direct transfers, i.e. extort from the society.
24
= [a – b (qi + qj)]qi – (c – θxi)qi – 2
2ix
σ + (1 li)sixi (54)
In order to understand the impact of this political economic setting first assume that firm j
refuses to make investment and therefore the government of B cannot subsidize even at si
= 1, as in the examination of externalities. Skipping the output stage of the game where
nothing changes the optimal investment by firm i can be calculated by the following
operations explained before:
πi = 2
ibq – 2
2ix
σ + ( ) iii xsl−1 (55)
∂πi/∂xi = 2bqi(∂qi/∂xi) – σxi + (1 li)si = 0 (56)
xi = ( )
289
1944
θσ
θθ
−
−+−
b
slbca ii (57)
Since there is no investment by firm j there is no system of investment functions to solve.
The effect of si on xi becomes:
∂xi/∂si = ( )
019
⟩∆
− ilb (58)
Since 0 < li < 1 the impact of one additional unit of subsidy on investment decreases.
Profit and domestic welfare are given by composite functions including the investment
function. Therefore the impacts of subsidy on profit and domestic welfare also decrease.
How about positive externalities? (50) above becomes:
∂xi/∂si = ( )
03
127⟩
∆
− il (59)
The same amount of subsidy now internalizes a smaller amount of externality.
Generalizing it can be stated that political economic considerations decrease the
effectiveness of policy instruments.
In order to maximize domestic welfare the effectiveness of the total amount of subsidies
should equal that of the subsidies given by (37); so the amount of subsidies distributed
increases because of political economic considerations. This decreases the social benefit
of profit-shifting.
25
Note that since qi and qj are strategic substitutes the externality of si on firm j has
decreased as well. Since both of the elements entering the decision algorithm of the
Commission decrease, political economic considerations do not have an impact on the
content of the SA decision.
However the analysis is not complete yet; because the above equations only take into
account the effect of the binding contribution schedule on the marginal impact of
subsidies. They say nothing about the optimality of the total amount of subsidies
distributed by G.
Let so be the optimal subsidy level for the benevolent government, without taking into
consideration the actual amount of subsidies. What is the optimal amount of subsidy for
the rent-seeking government?
The amount of contribution G gets according too (53) is a function of subsidies with the
FOC:
L' (si) = li (60)
Of course this does not give meaningful information; because the constraints of the
maximization problem has not been taken into account.
G does not have unlimited financial resources that can be utilized to generate subsidies.
The taxable income of the country equals its domestic welfare less any externalities, that
is P + πi. Since G wants to make a transfer from the rest of the society to the interest
group it should limit the taxable income with (1 χ). However in reality such a limitation
is only observed when transfers are made for the purpose of redistribution and not vice
versa. It is more realistic to assume that the taxable income is limited with P26
. The
maximization problem is:
max lisi, 0 ≤ si ≤ P
si
Since by definition si > 0, the value of si that solves the problem (si*) should satisfy the
following conditions: (1) L'(si*) ≥ 0 and (2) (b si
*) L'(si
*) = 0. Therefore si
* is P, the
entire taxable income of the society.
26
Why so? Governments avoid serving certain special interests explicitly and have recourse to
indirect and therefore inefficient (non-first-best) means. This phenomenon can be explained by
the fact that information is costly to obtain and so tax payers cannot understand that indirect means
are transfer from their pockets to those of the interest holders. Since the model presented here
does not take into consideration elections it is not necessary to deal with this analytically.
26
Given the weighted objective function G, the level of subsidy set by the government is:
G(si) = βso +(1 β)P (61)
Unless so is already P, the amount of the subsidy distributed by the government in a
political economic setting will be greater than the optimal strategic subsidy for any value
of β.
Note that this result holds when there are positive externalities. The internalization of
positive externalities beyond the optimal level is efficient. Therefore the value of the
internalization (the benefit) relative to the losses of firm j (the cost) decreases. As a result
the SA is more likely to be prohibited by the Commission.
This result is interesting; because it shows that even though the SA policy is designed to
prohibit subsidies that have an effect on the profits of the rivals, it is also beneficial for
the domestic welfare of the subsidizing MSs in the existence of political economic
considerations. This unintended consequence is consistent with the findings of
Dewatripont and Seabright (2006).
5. CONCLUSION
In order to enable a comprehensive evaluation of the SA policy of the EU this article has
presented a model that, for the first time in the literature, takes into consideration all three
reasons of government intervention in the markets and discusses European Commission’s
behaviour as a legal compliance maximizing agency. It has been shown that under the
SA policy subsidies given for the purpose of STP would certainly be prohibited unless
there are externalities that tilt the balance of the Commission’s cost-benefit analysis
towards permission. This possibility decreases when political economic considerations
are at work. The modelling exercise has also revealed that even though Article 87 is
designed to prevent negative effects of subsidies on the profits of the rivals, the SA policy
is also beneficial for curbing waste generated from intergovernmental competition, non-
reciprocal externalities and political economic considerations as unintended
consequences. Therefore despite its restrictive assumptions, most notably the utilization
of Cournot competition and third-market STP, the model presented above has proved
itself to be fruitful.
There remain, however, many issues in the SA policy that needs to be dealt with from an
economic perspective. First of all, the impact of different market characteristics, both in
terms of conditions of competition and market imperfections, on the distortions created
by subsidization should be examined in order to reach a more precise understanding of
cost and benefits associated with subsidies. This would certainly help the improvement
27
the application of the policy. Second, the interaction between the European Commission
and the MSs, and other relevant parties such as the Court of Justice of the European
Communities if necessary, should be taken into consideration. Uncertainty, an important
characteristic of the decision-making process of the SA policy that frequently witnesses
failure of notification and bargaining between the parties, and the possibility of the
capture of the Commission, most probably by informational lobbying, are two issues that
might prove to be interesting in this context. Third, the contradiction between the essence
of the control of SAs and other policies pursued by the EU, industrial policy in the
international markets and common policies of subsidization in the common market, most
prominently the Common Agricultural Policy and regional policy, should be explained.
Such an exercise would make a significant contribution to the understanding of the
political economy of international economics.
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