Question

Using the Brander-Spencer model, explain how the strategic trade policy can be work in the aircraft industry (example, Airbus vs Boeing)?

Answer 1

Answer

The Brander–Spencer model is an economic model in international trade that illustrates a situation where, a government can subsidize domestic firms to help them in their competition against foreign producers and in doing so enhances national welfare.

An example from the Aircraft industry

In this set up there are two firms, one foreign (Airbus) and one domestic (Boeing) which are considering producing "Big" aeroplanes. The demand is such that if only one firm produces, it will make a profit, but if they both produce each will make a loss, perhaps because of initial set up, infrastructure, product development, marketing or other fixed costs. The matrix below presents an example of the game that the two firms are engaged in.

Produce Don't Produce Produce −10, −10 50, 0 Don't Produce 0, 50 0, 0 Fig. 1

Produce Don't produce Produce 10, −10 70, 0 Don't Produce 0, 50 0, 0 Fig. 2:

The available choices of the domestic firms are given on the left, while those of the foreign firm are on top.

The game with no government subsidy to the domestic firm is shown in Figure 1 on the left. The two Nash equilibria of this game are the situations in which only one firm produces. In such a situation if the foreign firm has a slight initial advantage over the domestic firm the domestic firm will not produce and the foreign firm will.

The game changes however if the government credibly promises to subsidize the domestic firm if it produces, as illustrated in Figure 2. Suppose the government promises a subsidy of twenty million, regardless of whether the foreign firm produces or not. As a result, regardless of the action of the foreign firm, the domestic firm's incentive is to produce. Anticipating this, the foreign firm will stay out of the market itself, since otherwise it would incur a loss.

From the point of view of the domestic country, the subsidy is welfare improving. Additionally the domestic firm gains 50 million which would have otherwise gone to the foreign firm.