The Truth About Subsidies: Part 3

To conclude my subsidy blog posts this week, I will be talking about a common argument in favor of subsidizing companies based on “infant” status.  The subsidy blogs were motivated by a comment on my Recycling post suggesting that businesses cannot grow and prosper without some subsidies to which I disagreed. The first of my subsidy posts explained one common argument in favor of government funding for an activity based on whether it can be classified as a public good. I explained how recycling cannot be classified as both nonexcludable and nonrivalrous.  The second post explained that subsidies may be justified if there is a divergence of private and social benefits and the transaction costs are too high.  However, it is unclear that recycling has a different social benefit compared to a private benefit and thus that argument cannot justify recycling deserves government subsidies.

 

The third argument rests on the idea that new industries need time to establish and find economies of scale.  Not only do industries need time, but the idea is that if we want diversified industries and not have to rely on other countries for goods we must take the time to develop.  This argument was also hinted at by Jan in one of the comments on the first blog post.  Further, A.K. probed at this idea (and me) on this argument in his follow-up post after The Truth About Subsidies: Part 1.  In fact, he states:

“If all of the relevant costs are incorporated into the price mechanism (an assailable proposition), then the greater cost associated with recycling a plastic bottle versus producing one from virgin resources is per se evidence that recycling is actually counterproductive to the goal of resource conservation. If the price mechanism argument holds up, we should not merely oppose subsidization of recycling, but oppose recycling itself! This argument would hold so long as the relative cost dynamics hold.

But here’s another challenge, Danielle. Can we argue that we need the subsidy to help the recycling industry grow, become more sophisticated, and reverse the cost dynamics over time? “The recycling industry is an infant and needs time and support to become self-sufficient.” (emphasis added)

Particularly in the case of recycling, the infant argument would suggest that older competitors (trash collectors) have had time to attain economies of scale, while new industries with perhaps high fixed start-up costs have a difficult time competing due to these high costs.  This idea is a protectionist one and often the argument for quotas/tariffs on other countries.  New industries may also be at a disadvantage due to not having the necessary skills and knowledge to compete.  One may think of recycling as a relatively new business that only has been around for the  last couple of decades and knowledge on how to run a recycling center and build new equipment is also relatively new.

 

In a great article on infant industries related to international trade by Forbes they explain 3 main reasons why mature industries have a competitive edge over infant industries. I will sum them up briefly:

  1. Mature industries have trade secrets or patents that allow them to produce efficiently. (This is probably not as applicable to recycling as it is to different countries that may have a favorable patent over another country.)
  2. The mature industry has the correct environment or domestic infrastructure that allows it to efficiently produce a product. (This can be applicable to recycling if you think that access to machines and efficient processes will come over time.)
  3. Mature industries have a knowledgeable workforce and infant industries have employees that need time to acquire skills. (Definitely applicable in any new industry.)

However, there are some problems with giving infant industries, like recycling (if you think it should be considered an infant industry), subsidies.

 

One problem with giving firms’ subsidies under the notion that an “infant” firm needs time to grow into “adulthood” is that once firms obtain government subsidies they are reluctant to give them up.  It is like a parent who gives their child allowance and then one day cuts them off.  The child rarely accepts this without pouting, kicking or screaming—firms are the same. Further, some of these infant industries never actually grow and become cost effective, because they just use their political favor to keep collecting subsidies to offset costs.  These payments allow them to keep operating where in absence of them firms wouldn’t be efficient enough to stay in business.

 

Another problem that is caused by using subsidies to fund infant industries is that companies could abuse this privilege (i.e. rent-seeking) and simply claim that they need subsidies to grow their company.  It can become difficult to determine which industries (wind power, recycling, solar panels) actually have high costs and thus ‘need’ subsidies to have time to grow and compete with other energy competitors or whether they are just seeking government favor and monies. Determining which firms/industries deserve the money becomes a tricky question.

 

Lastly, the third problem that I can see is that subsidies change the relative pricing in the marketplace in favor of industries that get the subsidies.  The price mechanism changes with a subsidy and it makes the entrepreneur more likely to enter into the recycling business versus the trash collection business if recycling is subsidized (which it is).  It provides an incentive for workers to favor becoming educated in recycling versus trash collection when otherwise this may not be the case.

 

Subsidies help “infant” industries grow their business from a cost-intensive one to one that is self-efficient and profitable even without subsidies in some cases.  However, in other cases businesses may take advantage of subsidies and lobby politicians to keep subsidies even when they are no longer needed.  Further, these political connections may not provide the right incentives for firms to become efficient and some never do, yet still receive money.

 

One prominent Harvard economist published a paper on infant industries in relation to an argument for tariffs and quotas in international trade.  He finds that, “the decision to protect the industry should depend on the industry’s learning potential, the shape of the learning curve, and the degree of substitutability between domestic and foreign goods.”  This solution seems to be ideal in that each industry/firm is different and some can use help/time to become cost efficient producers.  However, this paper is theoretical and perhaps not really practical.  To know which industries actually have “learning potential” and determine a proper metric to measure this would be difficult at best.  Further, it may be also difficult to know the exact degree of substitutability between environmental goods (like recycling and trash collection) and thus how could the government ever efficiently allocate subsidies?

 

So, in some cases subsidies will help a business prosper and some they don’t. Does that mean we should have subsidies for infant industries?  To me, it depends on the role one feels the government should play in our lives.  If one believes the government is needed to help businesses grow and to allow for industry diversification then perhaps subsidies are warranted.  If one believes the government distorts relative prices with subsidies and allows for suboptimal job and resource allocation that would not occur in absence of subsidies then subsidies are not wanted.  Again, this depends on what you believe is the proper role of the government.

 

I, for one, prefer the private market to decide where resources are allocated.

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3 thoughts on “The Truth About Subsidies: Part 3

  1. Good job explaining things, but I think we may also ask the question that why do infant industries, if they cannot stand without government help, need to exist at all. Let us assume that we have economies of scale enjoyed by the entrenched technology, which the infant cannot possibly compete with. Is the argument for their existence that once they get to a substantial scale, prices would be lower than those for the competing existing technology and so “society”, whatever that means, would be better off? If so, private venture capitalists should be able to read the writing on the wall and in their greed for subsequent monopoly rents should grant the relevant fund all the capital it needs. Are we seriously considering the possibility that the government is able to better gauge what the cost structure of said tech will be in the future that the private players? If so, I have a bridge to sell. There is a reason that the such-subsidized industries come to the government with begging bowl in hand. They are not fiscally tenable in the view of the people who know business.

  2. Pingback: A True Free Market Economy | An Inside View

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