State Aid and Competition: Application of a Social Welfare Criterion to State Aid

Abstract

Within the European Union, state aid is prohibited unless it is provided under a specific exemption by the European Commission. The main motivation for state aid control follows from a partial welfare criterion. State aid, being selective, negatively affects competitors of the aid recipient firm. By applying a social welfare criterion instead, we find that state aid in the form of a production subsidy is beneficial to society for a surprisingly wide range of realistic market conditions and taxation costs. The intuition for this result is that under ‘imperfect’ market conditions—when prices exceed marginal costs—a production subsidy leads to more output and reduces oligopolistic inefficiencies. In a general market framework with cost differences and product differentiation, we balance this benefit with the costs of distortionary taxes needed to finance state aid. We derive the critical level of tax distortion that implies a general condition for welfare-improving state aid. Reasonable estimates of tax distortion are often below this critical level, indicating that the ban on state aid may exclude possibilities to increase social welfare. We formally prove that in any Cournot oligopoly, the critical value is strictly positive for at least one aid recipient firm. The potential for state aid to improve social welfare is found to be higher in less competitive markets, and when marginal costs of the subsidised firm are relatively low. Among other policy tools to correct market failures, using state funds to boost production may be a more appropriate option than generally considered. Our findings seem relevant in the ongoing policy debate on the application of a broad welfare criterion in state aid control in the European Union.