evren güldoğan- a theoretical framework for evaluating the state aid policy of the european union

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1 A THEORETICAL FRAMEWORK FOR EVALUATING THE STATE AID POLICY OF THE EUROPEAN UNION * Evren Güldoğan 183. Sokak 14/3 35280 Hatay/ĐZMĐR [email protected] 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 Union 1 (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.

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Page 1: Evren Güldoğan- A Theoretical Framework for Evaluating the State Aid Policy of the European Union

1

A THEORETICAL FRAMEWORK FOR EVALUATING THE STATE AID POLICY OF THE EUROPEAN UNION

*

Evren Güldoğan 183. Sokak 14/3 35280 Hatay/ĐZMĐR

[email protected]

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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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)

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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:

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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.

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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)

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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):

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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

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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)

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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.

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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.

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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.

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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):

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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

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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.

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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.

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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.

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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.

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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

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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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