6.5 Government Subsidies in an Open Economy

Before drawing any conclusions about the conduct of subsidy policy, it is as well to see how our analysis might have to be modified in order to take account of two important facts of life. The first is that industrial firms have become increasingly affected by international competition. The analysis used in Section 6.4 has the virtue of recognising that the subsidised firm is competing with foreign firms, that is to say that the economy is ‘open’. However, it is assumed that foreign competitors react entirely passively to the ability of the subsidised domestic producer to compete against them. This is hardly in keeping with the emphasis in this Course on the way firms behave in the light of changes in their economic environment. For example, one course of action that foreign competitors might adopt is to try to induce their own governments to introduce fiscal measures which put them in a better position to compete.

The second important feature of international trade in subsidised products is the absence of highly competitive conditions. If there are few competing firms, then instead of firms acting as if their selling price is beyond their control, they may recognise that they can individually influence the market price by their changes in output sold. Governments, as we have seen, are interested in firms providing technological spin-off such as those in the aircraft and information technology industries. These also happen to be industries characterised by few sellers, i.e. by oligopolistic conditions.

With these additional elements introduced to produce a more realistic scenario, subsidy policy is beset by a further problem. Consider our example in Section 6.4 again. A subsidy per unit of output will now not only encourage the domestic supplier to increase output, it will also encourage the firm to lower the domestic price as a way of ‘stealing’ custom from overseas rivals. Ignoring the ‘opportunity cost’ of the subsidy, this seem to call for ‘drinks all round’. Domestic buyers benefit from the consumers' surplus resulting from a lower price, and there is a redistribution of profits from overseas suppliers to the domestic firm. Overseas suppliers can react by reducing their price in order to compete, so it is to be expected that they will try to persuade their own governments to subsidise their output. In short, any perceived benefits from the use of subsidies in an open economy must take account of the reactions of foreign governments. Subsidy policy becomes a game played between competing governments whose incentive to subsidise a particular product will depend on the valuation placed on increases in its domestic output. However, this is complicated by having to calculate the economic advantages of trying to outbid foreign governments.