Essay: Variables that can dictate the effectiveness of a governmental subsidy on a firm or industry

In a world where medicine and technology form such an integral part of our culture, evolution and in some cases survival, research and development’which will be abbreviated to R&D in some parts of this thesis’is paramount to our progression through obstacles thrown at us by everyday life. Be it a more environmentally friendly vehicle, a computer processor that better allows scientists to analyse cures for exotic diseases or even something as simple as a more nutrient dense food to feed the starving, research and development allows firms to search for and make discoveries that make all of our lives easier and more efficient. Due to the limited amount of discoveries that can be made, however, the realm of research and development is a fiercely competitive one, with firms constantly trying to get an advantage over their competitors to increase their revenue and fund further R&D. This competitiveness can cause suboptimal social outcomes that stretch as far as market failure, which is unfortunate as the world of research and development has the potential to be a mutually beneficial environment where knowledge and information is shared in a socially optimal way, leading to the increased growth of firms and consequentially an improvement in a country’s technological prowess and overall economic health.
The question of whether or not the governmental subsidy of firms’ research and development is a worthwhile endeavour depends on several variables that will be discussed in this thesis. This is of course an important question, as a rational and efficient body such as a government should not continue to provide a firm or industry with subsidy if said subsidy was doing damage to either itself or the receiver, if its objective is economic growth. Also, if a firm’s ability to do research and development is hindered by a governmental subsidy, then this action should be stopped in order to let the firm progress and innovate in a more efficient and unburdened manner.
In the following chapters, I will discuss the aforementioned variables that can affect the effectiveness of a subsidy on a firm and also the mutualistic symbiosis that can occur through phenomena brought about by cooperation between firms within an industry. Through the use of a simple economic model and a wide array of academic papers written on the subject, one hopes to better the reader’s knowledge of how governmental subsidies can improve or worsen a firm’s ability to do R&D, how the aforementioned subsidies can affect the economy of a country and, ultimately, whether governmental subsidies are a good or bad idea. The relevant material and literature associated with this topic will be discussed in chapter 2. In chapter 3, we will discuss the Brander-Spencer model of governmental subsidy and a simple model will also be introduced. This model will attempt to explain the relationship between the size of a subsidy and the positive or negative welfare effect that it has on the firm. Chapter 4 will consist of the results and conclusions which can be drawn from an analysis of these models.
2. Overview of the Topic
The literature related to this topic discusses several variables that can dictate the effectiveness of a governmental subsidy on a firm or industry. One of the most prominent of these is a phenomenon known as knowledge spillover. This phenomenon is discussed in detail by Carlino (2001), Boja (2012) and Krugman & Obstfeld (1997). In short, knowledge spillover is an externality that can aid in the collective development of new technologies in a group of firms, and in some cases improve the economy of a country (Krugman & Obstfeld).
Jerry Carlino mentions two different types of knowledge spillovers in his article Knowledge Spillovers: Cities’ Role in the New Economy. These consist of MAR spillovers, developed by Alfred Marshall, where a concentration of firms within a similar industry help to stimulate each other’s growth and innovation, and Jacobs spillovers, conceived by Jane Jacobs in 1969, where a collection of firms benefit from the diversification of expertise and industry in an area of close proximity. We have to assume that the firms in question bare the cost of transporting knowledge, be it a person or package with new software et cetera, and so the best outcome for the firms involved would of course be to join together in a close community and share knowledge freely. In addition, Porter spillovers state that, should competitive firms be grouped together in such a close proximity’with the key word here being ‘competitive”then their level of innovative participation, along with knowledge externalities, will increase which will therefore stimulate growth of the firms and, consequentially, the industry (Audretsch & Feldman 2003). As innovation is the only option, the alternative would be to stop production or innovation in the firm, which we can assume would not be rational or viable. However, the concept of Porter spillovers assumes that the firms in the geographically concentrated area are aiding one another through innovation, instead of fighting for a single technology. Should we look at the situation from a realistic perspective, oftentimes firms in an industry will all at once be searching to discover a technology, so as to win the innovation race and patent the discovery. In this scenario, Porter spillovers become redundant, as the firms form a fiercely competitive environment instead of the aforementioned one of mutual benefit and innovative motivation. The level at which knowledge spillovers affect industry is largely dependent on the number of employees or firms, their proximity to each other and the diversity of industry in the area. In his paper Increasing Returns and Economic Geography, Krugman discusses the effect that location can have on firms’ interactions with each other and how firms that are more centrally located to a large city will have more success than firms located in a sparsely populated rural area, for example. This phenomenon is known as cluster success and depends largely upon the firms’ abilities to perform R&D, the competency of their employees and of course upon the willingness of the firms to cooperate with each other (Boja 2012).
Firms can choose to compete with each other or cooperate in R&D and in the production stages thereafter, each choice having a very different outcome regarding the success and profits of said firms in the market. If firms are chasing a monopoly position in a market then we can assume that neither firm will decide to cooperate with the other, both will do R&D and the firm that is most efficient regarding their R&D and innovation will succeed. However, D’Aspremont and Jacquemin create three situations, where firms do not cooperate at any level, cooperate solely at the research and development level and cooperate in both the research and development and the production of a product. Their findings suggest that cooperation in only the research and development stage yields both a higher level of R&D and a higher level of production in the competitive stages, depending on the level of spillover in the industry. This in turn allows the firms to charge a higher price for the product because of the lack of competition in the market, thus generating higher profits brought about by the reduction in the cost of research and development. This would go against the assumption that firms should strive to become a monopoly, as this would maximise their profits due to them having full control over the market price. This is also profitable due to a reduction in R&D expenditure and also due to a removal of the need for duplication (Shy 1995), where a rival firm will purchase a new technology and ‘reverse engineer’ it to better understand its working and usually to attempt to improve it.
Oz Shy describes a scenario in his book Industrial Organisation: Theory and Application where two firms partake in an ‘innovation race’ to discover a new technology in a market. Innovation is defined by Oz Shy as ‘the search for, and the discovery, development, improvement, adoption, and commercialization of new processes, new products, and new organizational structures and procedures’ (Shy 1995). In today’s world, innovation is seen as a wholly competitive activity, where smaller firms are almost always dominated by larger firms due to increased funding, more employees and improved technology. This deters firms from entering the market, thereby decreasing technological advancements and growth. Should the government subsidise the research and development of firms that are in constant competition with one another, surely this will promote a kind of monopolistic Natural Selection scenario, whereby the company with the most funding and the most intelligent lab technicians comes out on top. However, if the government were only to subsidise the weaker firms to give them a head-start over the market leaders, this can lead to a phenomenon known as infant industry, which is discussed in Krugman and Obstfeld’s International Economics: Theory and Policy. Here the authors describe a situation where a government subsidises a new industry’in our case we can look on it as a weak individual firm’in a developing country, in order to allow it to effectively compete against developed international industries. One would think that giving smaller firms a subsidy and, consequentially, a chance against more established firms would be a good idea, but there are several problems uncovered in the literature, the most prominent of which is the issue of market failure. Krugman and Obstfeld state that if a firm or industry is profitable enough, then surely it should be able to survive on its own through investments from private investors rather than depending on the crutch of government subsidies. One would think that subsidies given to a firm to fund research and development that could have been done by the firm without governmental subsidy would make said firm lazy and dependent on such monetary spoon-feeding, however this is disproven by the presence of a crowding out effect. This effect states that the extra subsidy received by the firm can help them to fund future projects, improve their facilities or increase their workforce, thus crowding out private R&D investment. (Lach 2000). Furthermore, should a firm be subsidised and hypothetically capture a market through the advantage gained by this subsidy, the firm may not be prepared for the burden of being a market leader or monopolist and could potentially cause a market failure.
Perhaps the most relevant literature I have read about the topic, namely the Brander-Spencer analysis and the subsequent game theory model connected to it, is contained within Krugman and Obstfeld’s International Economics: Theory and Policy. Here, Krugman and Obstfeld discuss the theory that a government can use subsidy to give domestic firms and industries an advantage over foreign firms and industries, thereby increasing the profit of the domestic firms and improving national welfare, which was made by Brander and Spencer in their paper Export Subsidies and International Market Share Rivalry. Krugman and Obstfeld simulate this using a simple game theory model containing two firms deciding whether or not to enter a market in another country. This model will be used extensively in my thesis and will be discussed in relation to firms deciding to engage in R&D.
For an example of research and development in the real world, we can look at the pharmaceutical industry in the UK, specifically cancer research. Pharmaceutical industries make up a large percentage of industries that are subsidised by the government, but the question remains: do they have anything to show for the money that has been pumped into them? According to a document written on the economic benefits of public and charitable funding of medical’and more specifically cancer’research in the UK, there is a large return generated in both the financial and health aspects of funding. The document states that approximately 40% of funding is returned into the British economy each year, meaning that a subsidy from the government into the medical industry would result in decent yearly economic returns. In order to see the full picture however, we must look past merely the monetary aspects of funding and observe the value of the health returns subsidy generates, measured in quality-adjusted life years (or QALYs). These are calculations determined by the life expectancy and quality of the remaining years in patient’s lives and act as another form of profit, showing that the research has an effect on the health of the population, and therefore a return. It is estimated that the ??15 billion invested in medical research from 1970 to 2009 has generated 5.9 million QALYs (2014). This shows that funding in the medical research industry has a large social and health return on investment, and is therefore worth investing in, should the government care about the wellbeing of the country’s population rather than focusing solely on monetary and economic aspects.
3. Analysis of the Models
Based on the literature that I have researched, the assumptions that can be made about the effects of governmental subsidy on a firm are:
a) It has a positive subsidy effect due to the crowding out effect described by Lach
b) It can be used to give a domestic firm an advantage over a foreign firm, which will be discussed extensively in this chapter
c) It can be used to increase the level of knowledge spillover in an industry, thus improving welfare and the technological prowess of said industry
We can use a modified version Obstfeld and Krugman’s game theory model of the Brander-Spencer analysis to show the effect of governmental subsidy on firms and how it can effect strategic interactions between them. We begin with two firms, Foreign Firm and Domestic Firm, taking the role of the row player and the column player respectively. We will assume that the two firms are competing for a market in which there only exists enough profit to sustain a monopoly, that is the winner takes it all and the loser leaves the market. If both firms decide to do R&D, the market will fail. This is also discussed by Oz Shy in Industrial Organization: Theory and Applications, where he shows that one firm doing research and development is the socially optimal outcome, as the market is not big enough for two firms to form a duopoly, but I digress. If one firm decides to do R&D while the other does not, the R&D firm will receive all of the profit and the other player will receive nothing, and vice versa.