SUBSIDIES AND COUNTERVAILING MEASURES IN THE EU BIOFUEL INDUSTRY: A WELFARE ANALYSIS

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Patrice BougetteChristophe Charlier

GREDEG WP No. 2020-38https://ideas.repec.org/s/gre/wpaper.html

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Subsidies and Countervailing Measures in theEU Biofuel Industry: A Welfare Analysis∗

Patrice Bougette † Christophe Charlier ‡

GREDEG Working Paper No. 2020–38

Abstract

In 2019, following several investigations, the European Union de-cided to impose definitive anti-subsidy (AS) duties on imports ofbiodiesel from Argentina and Indonesia. While AS duties protect thedomestic market and R&D, this trade defense policy may interferewith environmental preservation. We investigate this issue using aninternational duopoly model with an environmental externality. Wediscuss the economic rationale of AS measures in the biodiesel context.We show that the larger the size of the domestic market, the higherthe optimal AS level. Second, trade policies are less necessary whenfirms become more cost-efficient. Third, the sensitivity of AS policiesto environmental externalities is ambiguous. Fourth, under certainconditions, the success of the innovation is negatively correlated withthe strategic levels of both subsidies and AS policies.

Keywords: Anti-subsidy, countervailing duties, biodiesel, European Union, trade,environmental impact.JEL Classification: D43, F18, F13, Q48.

∗The authors would like to thank all participants at the first Nancy-Nice seminar (April2019), the ETSG conference in Bern (September 2019), the AFED conference (October2019) in Rennes, for their insights. The usual disclaimer applies.

†Universite Cote d’Azur, CNRS, GREDEG, France. Email: patrice.bougette@univ-cotedazur.fr.

‡Corresponding author. Universite Cote d’Azur, CNRS, GREDEG, France. Address:GREDEG CNRS, 250 rue Albert Einstein, CS 10269, 06905 Sophia Antipolis cedex, FranceEmail: christophe.charlier@univ-cotedazur.fr.

1 IntroductionThe European Union’s Green Deal, an ambitious plan to achieve carbonneutrality by 2050, has put emissions reduction as the main target.1 Theongoing energy transition has led to a procession of trade disputes. Thesehave been due to public policies promoting the development of renewableenergy.

A first wave of disputes emerged through the use of feed-in tariffs (FIT)programs, especially those with a local content requirement. The Canada–Renewable Energy WTO case constitutes a relevant example of these (Bougetteand Charlier, 2015; Rubini, 2015). From the perspectives of the claimants,FIT programs constitute illegal subsidies, and national content mechanismsare considered an infringement of the non-discrimination principle.2 Thencame a wave of antidumping (AD) disputes. These disputes, caused bydumping practices enabled by the subsidies of one party, either i) reacheda solution through bilateral negotiations on antidumping, or ii) have beendealt with at the WTO level in the absence of a negotiated solution. Thedisputes between China and the US and China and the EU over dumping andantidumping on solar panels are a good example of the first category (Hughesand Meckling, 2017; Bougette and Charlier, 2018).3 The disputes betweenthe EU and Argentina and Indonesia over antidumping on biodiesel belongto the second category. For instance, Fischer and Meyer (2020) provide ananalysis of the EU-Biodiesel (Indonesia) case and discuss the implicationsof the EU’s turn to protection. In one way or another, one can see thattriggering factor has been always the same: public supports of producers inthe renewable energy sector (Rodrik, 2014). This aid may impede free tradeand may confer an unfair advantage on the recipients, thus creating tensionsbetween trading partners (Lewis, 2014).

The article deals with a third type of disputes in this “family” relatedto subsidy and anti-subsidy (AS) programs. Since 2016 the EU has coun-

1The EU’s objective is to become the world’s first climate-neutral continent by 2050.See the European Green Deal – Communication from the Commission to the EuropeanParliament, the European Council, the council, the European Economic and Social Com-mittee and the Committee of the Regions, Brussels, 11 Dec. 2019, COM(2019) 640 final.

2Canada – Certain Measures Affecting the Renewable Energy Generation Sector, WTO,DS412.

3Bioethanol imported from the US is also under an European antidumping duty. SeeCommission Implementing Regulation (EU) 2019/765 of 14 May 2019, Official Journal ofthe European Union, L 126, 15.5.2019, p.4.

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tervailed export taxes on raw materials (soybeans) for biodiesel productionimposed by the exporting country governments of Argentina and Indonesia.Cases between the EU and Argentina on Argentina’s subsidies4 and betweenthe EU and Indonesia5 are the basis of this article. In 2012, the EU ac-cused the two countries of dumping their biodiesel and decided to imposeanti-dumping measures to protect its biodiesel industry. Argentina filed acomplaint against the EU at the WTO in 2013 and won the case in 2016.

The presence of Argentinean subsidies was recognized in the disputebut not discussed. The dispute rather concerned the EU estimation of thedumping margin (Crowley and Hillman, 2018). The EU took account ofthe government-created distortions to the price when computing the homemarket price of biodiesel. The Panel and the AB of the WTO refused thismethodology of assessing the “Normal Value” for the biodiesel in Argentina.As a consequence, the European AD measure on biodiesel was condemned.However, there was no dispute over the fact that Argentina’s tax system onexports has the effect of a production subsidy. In January 2018, the Euro-pean Commission opened an AS investigation to maintain its protection ofits biodiesel sector.6 In February 2019, the Commission imposed AS dutiesfrom 25% to 33.4%, and accepted sustainable price commitments exemptingeight Argentine producers and the Argentine Chamber of Biofuels from theduties within an agreed import limit.7

At first glance, this decision may appear odd. The EU has objectives inbiofuel development and limiting imports might hinder their achievement.8From Beghin et al. (2017) these objectives can be summed up as follows.

4Commission Implementing Regulation (EU) 2019/244 of 11 February 2019 imposinga definitive countervailing duty on imports of biodiesel originating in Argentina, OfficialJournal of the European Union, L 40, 12.2.2019, p. 1.

5Commission Implementing Regulation (EU) 2019/2092 of 28 November 2019 imposinga definitive countervailing duty on imports of biodiesel originating in Indonesia, OfficialJournal of the European Union, L 317, 9.12.2019, p.42.

6The EU can impose duties to counteract a subsidy, but only if it is limited to aspecific firm, industry or group of firms or industries. See Regulation (EU) 2016/1037of the European Parliament and of the Council of 8 June 2016 on protection againstsubsidized imports from countries not members of the European Union, Official Journalof the European Union, L 176, 30.6.2016, p. 55.

7See European Commission, “Commission puts in place duties on subsidized biodieselfrom Argentina”, Brussels, 13 February 2019.

8By 2020, 10% of the transport fuel in the EU should come from renewable sources.See https://ec.europa.eu/energy/en/topics/renewable-energy/biofuels.

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The EU biofuel policy is motivated by the reduction of GHG emissions.However, support for the European farm sector should not be disregarded.The EU policy concerns two areas. First, the Fuel Quality Directive9 and theRenewable Energy Directive aim at promoting the consumption of biofuel.Second, the intrinsic capacity of biofuel to reduce GHG is also targeted bythe policy, which sets mandatory GHG emission-saving thresholds. Thislatter aspect shows that, to give a clearer overview of the biodiesel AS case,the environmental performance of biofuel, as well as the protection of R&Din this sector reached with the help of trade barriers, must be considered.The present article precisely explores these issues from a theoretical point ofview.

Against this background, we shed some light on the above disputes bymodeling an international duopoly with intra-industry trade of biodiesel. Thepossibility of domestic R&D reducing the domestic biodiesel producer’s costof production, as well as improving the environmental performance of theproduct, is considered. First, assuming quantity competition, we establishthe conditions under which the domestic industry suffers an injury because ofthe foreign subsidy. The economic rationale for an optimal AS duty is thenpresented in a three-staged model. The conditions under which such a policycurbs fossil fuel replacement are in particular discussed. More generally,the article investigates the main determinants of an optimal AS strategy(maximizing the domestic welfare including an environmental externality).

The remainder of the article is structured as follows. Section 2 providesan overview of the related literature with an emphasis on the importance ofassessing the environmental impact of biofuel. Section 3 presents the modeland solves it by backward induction. Section 4 analyzes the results andprovides some interpretations. Finally, Section 5 concludes.

2 Related LiteratureThis article is related to at least three strands of the economics literature.The first refers to public policies supporting the energy transition and low-carbon solutions for the economy. This has led to green industrial policiessuccessfully popularized by Rodrik (2014). The objective of government in-terventions is to solve market failures, especially in domestic industries that

9Directive 98/70/EC of the European Parliament and of the Council of 13 October 1998relating to the quality of petrol and diesel fuels as amended by Directive 2009/30/EC.

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have environmental benefits (Jaffe et al., 2005). Rationales for these policiesare manifold: the development of new technologies and industries can com-bat climate change and create jobs and economic opportunities at the sametime. Furthermore, such industries may need assistance to become com-petitive, both because they are infant industries still innovating, developingsupport networks and scale economies, and also because their environmentalbenefits are not properly priced by the market. This relates to the wholeliterature on the benefits of well-designed industrial policies (Aghion et al.,2015, e.g.).

More particularly, these green policies range from downstream measuresto support deployment to upstream incentives for R&D and manufactur-ing. For instance, Fischer et al. (2018) examine the rationale for supple-mentary subsidy policies when countries have already set their renewableenergy targets. With twin market failures, Fischer et al. (2017) consider therelative effects and desirability of subsidies for pollution abatement technolo-gies. They find that downstream subsidies tend to increase global abatementtechnology prices, reduce pollution abatement abroad, and increase emissionleakage. On the contrary, upstream subsidies reduce abatement technologyprices, and hence also emissions leakage.

A second strand of the literature refers to the consequences of public sup-port actions in the international trade arena. A growing number of disputesamong countries concern elements of the energy transition (e.g., biodiesel,solar panels, feed-in tariffs, solar equipment technologies). Regarding theEU-biodiesel case, the price of soybeans in Argentina was distorted by theexistence of an export tax scheme that resulted in artificially low soybeanprices. Crowley and Hillman (2018) analyze the economic rationale for suchan export tax system and distortions in biodiesel markets in Argentina andthe EU. From an economics perspective, they show that the export tax onsoybeans conferred a financial benefit on biodiesel producers that was similarto a production subsidy but had the added benefit of placing European play-ers at a cost disadvantage by raising the price of soybeans on world markets.Zhou (2018)’s case-law analysis sheds some light on the WTO’s challengesdue to the rise of disputes involving China’s state capitalism.

A last strand of literature focuses on the characteristics of the biodieselindustry, its evolution, its environmental stakes, and the impact on fossil fueland vegetable oil prices (Peri and Baldi, 2013; Purkus et al., 2019, e.g.). Forinstance, Beghin et al. (2017) analyze the impact of a potential US-EU freetrade agreement. The authors calibrate a multi-market model that incor-

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porates the spatial aspect of bilateral trade flows for biofuel and feedstockmarkets and associated major crops competing for land use. They find thatEU sustainable criteria for biofuels should be monitored for future changesmotivated by European Indirect Land Use Change (ILUC), which could in-validate the current sustainable status of most biofuels, with the exceptionof Brazilian ethanol. Notably, ILUC can occur when land previously devotedto food or feed production is converted to produce biofuels in our case. Foodand feed demand still needs to be satisfied, which may lead to the exten-sion of agricultural land into areas with high carbon stock such as forests,wetlands and peat land, causing additional greenhouse gas emissions. Thiscreates a “biofuel carbon debt” (Fargione et al., 2008).

Innovation in the biofuel sector appears to be strategic. There are twotypes of biofuels. The “first generation” or conventionally produced biofuelsare biofuels produced from food crops, such as sugar. They are produced fromland using feedstock which can also be used for food and feed. “Second andthird generation” or advanced biofuels are produced from feedstock that donot compete directly with food and feed crops, such as wastes and agriculturalresidues, non-food crops, or algae. From an environmental point of view,investing in innovation leads to reduce a reduction in the negative impact ofbiofuel on the environment. Actually, Kessler and Sperling (2016) plead fortechnology-push policies more focused on R&D and investment. They wouldfoster the commercialization of 2nd generation biofuels.

Searchinger et al. (2017) and Doumax-Tagliavini and Sarasa (2018) showthat the carbon costs of dedicating land to bioenergy will exceed the ben-efits if one continues to use first-generation biofuels. German et al. (2017)formulate a series of sine qua non for national biofuel programs with the aimof enhancing their social and environmental sustainability. They discuss theglobal repercussions of national policy choices and identify the acceptabilityof the trade-offs associated with alternative production scenarios.

In the following section, we provide a model that incorporates the inno-vation issue and its dual impact on the environment.

3 The ModelWe assume that the market for biodiesel is an international duopoly. Morespecifically, we focus on the domestic market in which a differentiated biodiesely is provided by a foreign firm (denoted 1) and a domestic firm (denoted 2)

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in quantities y1 and y2 respectively. The two firms are assumed to compete ala Cournot on this market.10 We suppose these firms to have symmetric con-stant marginal costs, c > 0. However, the domestic Firm 2 opts for an R&Dstrategy to break this symmetry to its advantage, which has a probability ρof success. In case of success, the efficiency gain is denoted e (with c−e > 0).We assume that another possible R&D outcome exists (with probability ρ),in which the domestic biodiesel’s environmental efficiency is improved.

Biodiesel is supposed to replace fossil fuels in order to reduce a fuel con-sumption externality, E, written as

E = F − (1 − ε)y1 − ρ!1 − (ε − r)

"y2 − (1 − ρ)(1 − ε)y2 . (1)

In this definition F represents the fossil fuel consumption and (1 − ε) corre-sponds to the environmental efficiency of biodiesel. Two initial assumptionsare related to these parameters.

Assumption 1 The fossil fuel consumption F is high enough so that theenvironmental externality is always positive (E > 0).

This first assumption allows the focus to remain on cases where the fossilfuel externality always exists, irrespective of the development of biodiesel(y1 + y2).

Assumption 2 The environmental efficiency of biodiesel is lower than one,1 − ε < 1.

This assumption makes it possible to consider that producing biodiesel actu-ally emits GHG. From an environmental perspective, one gallon of biodieselcannot fully replace one gallon of fossil fuel. When these biodiesel productionemissions are “too high”, the environmental efficiency of biodiesel is negative(1 − ε < 0) and the biodiesel production increases the amount of externalityE (instead of reducing it). As presented in Section 2, since a controversyexists in the economics literature on the net effect of biodiesel productionon GHG emissions, it is worth introducing the possibility of a negative en-vironmental efficiency into the modeling. The final assumption regardingthe externality describes how the environmental efficiency of the domesticbiodiesel is impacted by R&D.

10In the following, the foreign market is not modeled to remain explicitly within thecontext of the dispute between the EU and Argentina (respectively the domestic countryand the foreign country in the modeling).

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Assumption 3 Using R&D, the domestic biodiesel reaches a higher effi-ciency (1 − (ε − r)) with a probability ρ. The gain in efficiency r is such that(ε − r) < 1.

From an environmental point of view, a successful R&D always improvesthe environmental efficiency of the domestic biodiesel to the point that evena biodiesel that originally has increased GHG emissions reduces the overallexternality after R&D.

The indirect utility function for domestic consumers enables the consid-eration of horizontal product differentiation. This is written as

U = ay1 + y2 − 12b

!y2

1 + 2φy1y2 + y22

"+ y0 , (2)

with 0 < φ < 1 denoting the degree of horizontal product differentiation,y0 > 0 the numeraire, and a > 0 and b > 0 are strictly positive demandparameters.

The foreign country supports Firm 1’s export production using a subsidy.This subsidy increases the foreign firm’s marginal revenue by the value of s(with s < c). An AS policy is chosen by the domestic country in reactionto the foreign subsidy. This domestic policy takes the form of a unit dutyτ applied on the foreign biodiesel. Throughout the article, only settings inwhich the subsidy and the AS exist are considered (s > 0 and τ > 0).

The model consists of three decisions and is solved by backward induction.In Stage 1, the foreign country chooses its level of subsidy s. In Stage 2, thedomestic country chooses its AS duty τ to counteract the foreign subsidypolicy. In Stage 3, both firms compete a la Cournot on the domestic biodieselmarket. We now solve for the subgame perfect equilibrium of the game,beginning in Stage 3.

3.1 Competition on the biodiesel market (Stage 3)The demands for the two types of biodiesel supplied in the market are derivedfrom the maximization of the utility function (2) under the following budgetconstraint R = y0 + (p1 + τ)y1 + p2y2. The demand functions are computedsolving the first order conditions (the second order conditions are satisfied,

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too):

y1 = a(1 − φ) − (p1 + τ) + φp2

b(1 − φ2) (3)

y2 = a(1 − φ) − p2 + φ(p1 + τ)b(1 − φ2) (4)

The profit functions of the two firms are given by:

π1(y1) = p1y1 − (c − s)y1 (5)π2(y2) = p2y2 −

!ρ(c − e) + (1 − ρ)c

"y2 − d , (6)

where d denotes the fixed cost of R&D in the domestic firm’s profit function(6). The maximization program of Firm i’s profit is written such as

maxyi

#πi(yi)

$(7)

The second order conditions of profit maximization are met. The equilibriumquantities of biodiesel are therefore given by:

y!1 = a(2 − φ) − 2(c − s + τ) + φ(c − ρe)

b(4 − φ2) (8)

y!2 = a(2 − φ) − 2(c − ρe) + φ(c − s + τ)

b(4 − φ2) (9)

Equilibrium prices can be written as the following

p!1 = a(2 − φ) − 2(s + τ) − φ(eρ − sφ) + c(2 − φ)(1 + φ)

4 − φ2 (10)

p!2 = a(2 − φ) − 2eρ + φ(ρeφ − s + τ) + c(2 − φ)(1 + φ)

4 − φ2 (11)

The resulting equilibrium profit functions are presented in the appendix.

3.2 The optimal domestic anti-subsidy policy (Stage2)

In Stage 2, the domestic government chooses the optimal AS level to maxi-mize domestic welfare, considering the consequences of its policy on compe-tition on the biodiesel market, as well as on the environment.

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The domestic welfare function has four components: i) the biodiesel con-sumer surplus, ii) the biodiesel producer profit (6), iii) E, the environmentalexternality due to fuel consumption (1), valued at a price γ, and iv) the rev-enue, τy1, raised by the domestic AS policy. The domestic welfare is thereforegiven by the following expression

W2 = CS + π2 + τy1 − γE . (12)

One can explore the sign of the different components of the domestic wel-fare with respect to the AS rate τ . As intuition suggests, consumer surplusdecreases with the AS duty, contrasting with the biodiesel producer’s domes-tic profit (∂CS/∂τ < 0 and ∂π2/∂τ > 0). However, the impact of AS duty onboth the AS revenue and the externality remains ambiguous. Leaving asidethe AS revenue, these results show that together with the conflicting interestof the biodiesel producer and the consumers, the regulator should take intoaccount the ambiguous effect of its trade policy on the environment. Notethat this is an important point only in situation where the biodiesel devel-opment reduces the externality. When the environmental efficiency of thebiodiesel is negative, the externality decreases with the AS duty (whereasthe sign of the derivative is ambiguous when the environmental efficiency ispositive).

We can compute the value of W2 at the equilibrium, W !2 , by replacing

equilibrium characteristics of Stage 3. The consumer and producer surpluses,as well as the externality, computed at the equilibrium, are reported in theappendix. The maximization of the domestic welfare program

maxτ

#W !

2 (s, τ)$

leads to the best-reply function τ(s)

τ(s) = 13

%

s + (a − c) + γ!(2 − φ)ε + (1 + rρ)φ − 2

"&

. (13)

The second order conditions are met.11 As expected for such a trade policyinstrument, the higher the subsidy, the higher the optimal AS duty. Thissimply highlights the role of the AS policy as a domestic countervailing mea-sure.

11 ∂2W !2

∂τ2 = − 3b(4−φ2) < 0.

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Two further remarks can be made. First, the net effect of R&D on theoptimal AS duty is always positive (the portion of τ(s) explained by R&D is13ρrγφ > 0). Therefore, the presence of R&D gives the domestic governmentadditional reasons to protect its market. Interestingly, the higher the envi-ronmental issues (γ), the larger this effect. Second, the best-reply functionτ(s) is not necessarily strictly positive. Under certain circumstances, definedwith cumulative constraints on the parameters, it can be negative.12 How-ever, throughout the analysis, we only refer to the positive interval of τ(s),otherwise τ remains null (in this case no AS duties are used).

3.3 The optimal foreign subsidy policy (Stage 1)In the first stage of the game, the foreign country chooses the level of subsidys! that maximizes the foreign welfare, anticipating the reaction τ(s) of thedomestic country. We assume that foreign welfare W1 is limited to Firm 1’sprofits. It does not consider the environmental externality. In such a context,the foreign subsidy is purely strategic, supporting the foreign biodiesel indus-try. As detailed in the introduction, this fits perfectly with how Argentinaconceived its biodiesel subsidy program.

Each euro of subsidy has an opportunity cost µ > 0. We suppose that theforeign country takes into account the opportunity cost of the total subsidyexpenditure µsy1 while computing s!. To avoid situations in which the for-eign regulator finds it profitable to set a negative subsidy (a tax), we assumethat µ < 1. The foreign welfare at the equilibrium is given by

W !1 = π!

1 − µsy!1 . (14)

The maximization program of the foreign country can be written as

maxs

#W !

1 (s, τ(s))$

The result gives the optimal foreign subsidy

s$ = (8 − 3µ(4 − φ2))((3(a − c + eρ) + 2γ(1 − ε + rρ))φ − 4(a − c + γ(1 − ε)))8(4 − 3µ(4 − φ2)) (15)

12For example, when the market size for a biodiesel with a positive environmental ef-ficiency (1 − r < ε < 1) is relatively small (a ! s − c), in a situation where the R&Doutcome is relatively weak (r ! 1

2 ), with a small probability of success (ρ ! 1−εr ), the

optimal answer to the foreign subsidy is a negative τ .

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with µ > 43(4−φ2) to ensure the existence of a maximum.

Plugging expression (15) in (13), one can obtain the value of the optimalAS duty τ ! at equilibrium

τ ! = 13

's! + a − c + γ

!φ(1 + rρ) + ε(2 − φ) − 2

"(. (16)

The values of (15) and (16) are plugged into the market characteristics ofStage 3 to obtain the subgame perfect equilibrium. We first examine theexpected equilibrium characteristics. Parameter a, size of demand, increasesboth values. The marginal cost of production has a negative impact on thequantities and a positive impact on the biodiesel prices of both firms.

Concerning the parameters related to innovation, the reduction in margin-al cost following innovation e has a positive impact on the innovator’s out-put (y!

2 increases) and a negative impact on the competitor’s output (y!1

decreases). The benefit of innovation on biodiesel efficiency – parameter r –positively impacts the domestic firm to the detriment of the foreign biodieselproduction. An increase in r leads to an increase in the prices of Firm 2 (theimpact on Firm 1 is ambiguous).

In the next section, we specifically study the endogenous variables s andτ at equilibrium.

4 Results and discussionIn this section, we provide the results of the three-staged model using com-parative statics on the two public policy instruments, namely the optimalcountervailing duty and the optimal foreign subsidy. The propositions em-phasize three broad categories: (i) market characteristics, (ii) firm character-istics, and (iii) environmental and innovation characteristics. In each case,we illustrate with simulations and discussion elements related to the biodieseldisputes.13 All the results and simulations meets the following constraints:(i) the existence of the subgame perfect equilibrium, (ii) the positivity of theoptimal subsidy and AS duty, (iii) the existence of welfare maxima (i.e., thevalue of the opportunity cost of the foreign subsidy should not be too low).

13Both the formal demonstrations and the derivative calculations are listed in the ap-pendix of the article.

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Proposition 1 On the demand side, both optimal foreign subsidy and do-mestic AS policies increase with the size of the domestic market.

Proposition 1 investigates the impact of the size of the domestic market onthe two public policies. A larger domestic market needs more protection(∂τ !/∂a > 0). Anticipating domestic protection, the foreign policy reacts byproviding more support to its firm (∂s!/∂a > 0).

No sufficiently clear-cut results emerge as to the impact of greater hor-izontal product differentiation on the two policies. A simulation exerciseshows that over a certain range of parameters ensuring market activity, thetwo strategic variables at equilibrium τ ! and s! decrease with parameter φ(see for instance Figure 1 in the appendix).

A second result explores how the optimal public policies also depend onthe firms’ characteristics.Proposition 2 The optimal level of the two strategic trade policy instru-ments (i.e., export subsidies and AS duties) decreases as a function of thedomestic and foreign firms’ marginal costs.From the perspective of the foreign country, as its firm becomes more ef-ficient (∂s!/∂c < 0), it is optimal to subsidize it less. The same is truefor the domestic country because a more efficient firm needs less protection(∂τ !/∂c < 0).14 Figure 2 in the appendix illustrates this result by plottingthe two strategic variables s! and τ ! as a function of the marginal cost ofthe two firms. Both functions are clearly decreasing. It can be seen that thevalue of the AS response is always lower than the one of the foreign subsidy.

A series of results highlights the impact of the optimal AS duty on theenvironmental stakes.Proposition 3 (i) The sensitivity of the optimal AS duty to both values ofthe externality γ and the environmental efficiency of biodiesel ε is undeter-mined. (ii) The optimal AS duty reacts differently to an improvement of theenvironmental efficiency of biodiesel, depending on its source (ε or r). (iii)When the biodiesel environmental efficiency is negative, the optimal AS dutyincreases with the value of the externality only if the degree of substitutionbetween the domestic and foreign fuels is sufficiently low.

14We have also tested a version of the model with a cost asymmetry to introduce relativeefficiency. However, we did not reach any salient results.

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Two environmental characteristics can influence the optimal AS duty:the environmental value γ of the fossil fuel externality and the efficiencyof biodiesel 1 − ε. The direct consequence of Proposition (3i) is that theintuitive case where the regulator should reduce its optimal AS duty forenvironmental benefits (an increase in γ or a decrease in ε) is not a generalresult and appears only in specific cases. These cases depend on the variouscharacteristics of the model. For example, if the environmental efficiency ofbiodiesel is weak (i.e., ε > ρφ

2−φ), the optimal AS duty decreases with the

value of the externality γ, whatever the value of γ, if the market size a andthe degree of substitution between the two biodiesels φ are sufficiently high(a > 4c−3φ(c−ρe)

4−3φand φ2 > 12µ−8

3µ).

As noted above, the biodiesel environmental efficiency depends on twocharacteristics: it is negatively linked to ε and positively linked to r. How-ever, the optimal AS duty reacts differently to an improvement of the en-vironmental efficiency in function of its source as underlined by Proposition(3ii). The conditions under which the optimal AS duty decreases becauseof a lower ε are exactly the same as those under which it increases due to ahigher r. In the first case, the improvement of the environmental efficiencyof biodiesel via a lower ε concerns both types of biodiesel. As a consequence,the regulator is prompted to take account of the environmental stake of theforeign biodiesel and moderates the optimal AS duty. In the second case,things are different since the increase in the environmental efficiency via ahigher r is the result of the domestic R&D, and thus concerns the domesticbiodiesel only. In these circumstances, the improvement of the environmen-tal efficiency of the domestic biodiesel gives the domestic regulator reason todefend its industry by raising its optimal AS duty.

When the environmental efficiency of biodiesel is negative, Proposition(3iii) states that the optimal AS duty increases with γ as soon as the degreeof substitution φ is sufficiently low (φ <

)20µ−8

5µ). As already noted, the

R&D (protected by the AS duty) takes place in the domestic country onlyand has two consequences: making the environmental efficiency of biodieselpositive and decreasing the domestic producer’s cost. When the degree ofsubstitution between the two goods is relatively low, the reduction in thecost may be insufficient to give a decisive advantage to the domestic pro-ducer. In these circumstances, when more weight is given to the externalityin the domestic welfare because of a greater γ, the regulator has an incen-tive to give more protection to the domestic biodiesel (the only one having a

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positive environmental efficiency with probability ρ) is given to the regulator.

Finally, one can examine the properties of the optimal subsidy and ASduties when R&D characteristics evolve.

Proposition 4 (i) Both the optimal AS and subsidy levels decrease with thereduction in marginal costs due to R&D. (ii) The higher the probability ofR&D success, the lower the levels of both optimal AS and subsidies, providedthat the opportunity cost of the foreign subsidy is not too low, ranging between

83(4−φ2) < µ < 1 .

When the domestic regulator has to set its level of AS duty, it has to takeinto account the impact of the success of the innovation on Firm 2’s efficiencybut also on the environment.

Thanks to the success of innovation, from a domestic policy point of view,there is less need to protect the firm that has become more efficient by anamount e. Therefore, the optimal level of AS duty decreases (∂τ !/∂e < 0).Through the inverse best-reaction function, we show that the foreign countryreacts in the same direction and then reduces its subsidy policy (∂s!/∂e < 0).

The higher the likelihood of R&D success, the less need to protect thedomestic firm as it becomes more efficient, to the detriment of its rival. Ifthere is less protection on the part of the domestic country, the best foreignresponse is to reduce its support policy as well, as shown in the inverse func-tion of (13). All this is provided that the opportunity cost of the subsidy isnot too low. If the latter ever decreases, then it becomes optimal for the for-eign firm to increase its policy of supporting its firm and by complementaritythe national regulator adjusts by also reinforcing its AS policy.

In the appendix to the article, Figure 4 illustrates the first case of Propo-sition 4. Both the subsidy and AS policies are decreasing functions of theprobability of success of the innovation. We are in the case where the op-portunity cost of the foreign subsidy is not too low (µ = 0.4375). It is thenoptimal for the domestic country to reduce its AS policy. In this setting,innovation increases domestic welfare (Figure 5).

5 ConclusionThis paper discusses the impact on the environment of trade policies decidedin the context of trade disputes. More precisely, we consider the environmen-

15

tal consequences of subsidies and AS duties on biodiesel using a three-stagemodel in which these policies are strategic complements. The model aimsat highlighting from a theoretical point of view the variables (particularlythose related to the environment) that should be considered when makingdecisions about AS measures.

We first derive a series of results focusing on the market and the firmscharacteristics that are determinants for the two trade policies considered.We show that the larger the size of the domestic market, the higher theoptimal AS duty. We also stress how trade policies are less necessary whenfirms become more cost-efficient. In other words, firms that are less efficientneed strong public policy, and vice versa.

Then, we show that the sensitivity of AS policies to environmental ex-ternalities is ambiguous. Intuition would suggest that the national regulatorshould lower its level of AS on biodiesel if environmental interests are atstake. We show that this framework only happens under very specific con-ditions. We also show that AS policies react differently depending on thesource of the improvement in the environmental efficiency of biodiesel. Thisis due to the fact that environmental innovation impacts only the domes-tic biodiesel. Finally, we explore the consequences of R&D characteristicson trade policies, highlighting that the success of innovation is negativelycorrelated to the levels of both strategic policies, provided the value of theopportunity cost of the subsidy is high.

This framework for modeling a bilateral dispute lays the foundation forfuture research on international disputes. The structure of the model allowsa significant number of key variables to be considered in studying the opti-mality of public policies, using simulations where appropriate to explore thepossibility of different scenarios. This seems especially important in a contextwhere the WTO trade disputes settlement system is under grave challengewith the rise of bilateral solutions in the meantime.

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AppendixEquilibrium characteristicsStage 3

When the domestic firm invests in R&D, the equilibrium profits are givenby:

π!1 =

'a(2 − φ) − c(2 − φ) + 2(s − τ) − eρφ

(2

b!4 − φ2

"2

π!2 = 1

4 − φ2

%

4(4bd + (a − c + eρ)2) + 4φ(a − c + eρ)(a − c + s − τ)

+ bdφ4 − ((a − c + s − τ)2 + 8bd)φ2&

18

Stage 2

The domestic consumer surplus CS can be computed using the followingexpression

CS = U2 − y0 − (p1 + τ)y1 − p2y2 (17)

Plugging equilibrium prices and quantities – expressions (8) to (11) – intoexpression (17) gives the consumer surplus value denoted CS!.

CS! = 1(2b(2 − φ)2(2 + φ)2)

*

+8a2−16ac+8c2+8as−8cs+4s2+8aeρ−8ceρ+4e2ρ2

−8aτ+8cτ−8sτ+4τ 2−6a2φ2+12acφ2−6c2φ2−6asφ2+6csφ2−3s2φ2−6aeρφ2

+6ceρφ2−3e2ρ2φ2+6aτφ2−6cτφ2+6sτφ2−3τ 2φ2+2a2φ3−4acφ3+2c2φ3

+2asφ3−2csφ3+2aeρφ3−2ceρφ3+2esρφ3−2aτφ3+2cτφ3−2eρτφ3),

-

Plugging expressions (8) and (9) in (1) gives E!, the value of the environ-mental externality at the equilibrium of Stage 2.

E! = γ

*

+F + (1 − ε)(2(c − s + τ) − a(2 − φ) − (c − eρ)φ)b(4 − φ2)

+(1 − ε)(1 − ρ)(2(c − eρ) − a(2 − φ) − (c − s + τ)φ)b(4 − φ2)

+(1 − (ε − r))ρ(2(c − eρ) − a(2 − φ) − (c − s + τ)φ)b(4 − φ2)

,

-

Then, one can compute the value of the domestic welfare using expression(12)

W !2 = 1

2b(4 − φ2)

*

+ − 8bd + s2 − 8bFγ + 4sγ − 4sγε + 4eγρ − 4eγερ + 3e2ρ2

+4erγρ2 + 2sτ − 4γτ + 4γετ − 3τ 2 + 2a2(2 − φ) + 2c2(2 − φ)

−2s(γ − γε + eρ + rγρ)φ + 2γ(τ − ετ + rρτ − e(1 − ε)ρ)φ

19

+2b(d + Fγ)φ2 − 2c(s + τ + eρ(3 − φ)

−γ(2ε − rρ − 2)(2 − φ) − sφ)

+2a(s + 3eρ + γ(4 − 4ε + 2rρ) + τ − 2c(2 − φ)

−(s + eρ + γ(2 − 2ε + rρ))φ),

-

Stage 1

One can compute the value of the foreign welfare at the equilibrium of Stage1 using expression (14).

W !1 = (2(c + τ − s) − a(2 − φ) − (c − eρ)φ)(2(c + τ + (2µ − 1)s) − a(2 − φ) − (c − eρ + sµφ)φ)

b(4 − φ2)2

ProofsProof of Proposition 1

The derivatives with respect to market size and their signs are the following

∂τ !

∂a= 1

24

'4 + 3φ − 4(4 − 3φ)

4 − 3µ(4 − φ2)

(> 0

∂s!

∂a= (4 − 3φ)(3µ(4 − φ2) − 8)

8(4 − 3µ(4 − φ2)) > 0

Proof of Proposition 2

The derivatives with respect to marginal costs and their signs are the follow-ing

∂τ !

∂c= 1

24

' 16 − 12φ

4 − 3µ(4 − φ2) − 3φ − 4(

< 0

∂s!

∂c= (4 − 3φ)(8 − 3µ(4 − φ2))

8(4 − 3µ(4 − φ2)) < 0

20

Proof of Proposition 3

The optimal AS duty is given by (16).(i) Its derivative with respect to the environmental value γ is the follow-

ing:

∂τ !

∂γ= 1

3

*

+ε(2−φ)+φ(1+rρ)+

!2φ(1 − (ε − rρ)) − 4(1 − ε)

"!8 − 3µ(4 − φ2)

"

8(4 − 3µ(4 − φ2))) −2,

-

On the basis of the assumptions made regarding the various parameters ofthe model its sign is ambiguous.

(ii) the derivatives with respect to ε and to r are the following:

∂τ !

∂ε=

γ!2 − φ

"!8 − 5λ(4 − φ2)

"

4!4 − 3λ(4 − φ2)

"

∂τ !

∂r=

γρφ!8 − 5λ(4 − φ2)

"

4!4 − 3λ(4 − φ2)

"

The signs of these derivatives are ambiguous. However, as γ, ρ, φ, and 2 − φare positive under the assumptions made in the model, it is straightforwardgiven the expressions written above that ∂τ ∗/∂ε and ∂τ ∗/∂r have the samesign under the same circumstances.

(iii) When ε > 1, ∂τ!

∂γgiven below is positive if: a > 3φ(c−ρe)−4c

3φ−4 , γ <4(a−c)+3φ(c−ρe−a)

4(ε−1)+2φ(1−(ε−ρr)) , and φ2 < 20µ−85µ

. When the latter condition is relaxed (i.e.,when φ2 > 20µ−8

5µ), while the two others are maintained, ∂τ!

∂γ< 0.

Proof of Proposition 4

The derivatives with respect to the probability of R&D success are the fol-lowing

∂τ !

∂ρ= 1

24φ

*

+3e + 10rγ + 3(e + 2rγ)4 − 3µ(4 − φ2)

,

- ,

∂s!

∂ρ= φ(3e + 2rγ)(8 − 3µ(4 − φ2))

8(4 − 3µ(4 − φ2)) .

21

The signs of the derivatives are ambiguous and depend on the range of pa-rameter µ. Regarding the effect of a change in e on the two optimal publicpolicies, one can show an ambiguous sign of the derivatives.

∂τ !

∂e= ∂s!

∂e= 1

8ρφ

%

1 + 44 − 3µ(4 − φ2)

&

< 0 .

Figures

Optimal foreign subsidy

Optimal AS

0.035 0.040 0.045 0.050�

5

10

15

20

25s*,�*

Figure 1: Foreign support and domestic AS duties at equilibrium decreasewith horizontal product differentiation in the domestic market (a = 100,b = 100, c = 98, d = 1, F = 133, e = 50, ρ = 0.9607, r = 0.3669, γ = 428,ε = 0.9907, µ = 0.35)

22

Optimal foreign subsidy

Optimal AS

18 19 20 21c

5

10

15

20

25

s, �

Figure 2: Optimal subsidy and AS duties decrease with firms’ marginal costs(a = 21.1, b = 38, d = 0, F = 73, e = 2.0527, φ = 0.5294, ρ = 0.8137,r = 0.3755, γ = 4.2272, ε = 0.4130, µ = 0.3802)

0.15 0.20 0.25 0.30�

1.361

1.362

1.363

1.364

�

Figure 3: Optimal AS duties decrease with environmental externality (a = 3,b = 1, c = 0.9921, d = 0.2, F = 1, e = 0.5, φ = 0.5, ρ = 0.0078, r = 0.5,ε = 0.75, µ = 0.4375)

23

Optimal foreign subsidy

Optimal AS

0.0 0.2 0.4 0.6 0.8 1.0�

1.4

1.6

1.8

2.0

2.2s, �

Figure 4: Optimal subsidy and AS duties decrease with the probability ofdomestic R&D success (a = 3, b = 1, c = 0.9921, d = 0.2, F = 1, e = 0.5,φ = 0.5, r = 0.5, ε = 0.75, µ = 0.4375)

Figure 5: The higher the likelihood of R&D success, the higher the domesticwelfare (a = 3, b = 1, c = 0.9921, d = 0.2, F = 1, γ = 0.0625, φ = 0.5,r = 0.5, ε = 0.75, µ = 0.4375)

24

Figure 6: AS duties and the impact of innovation on the environment candecrease domestic welfare (a = 45.75, b = 207, c = 23, d = 0.2, F = 0.1,γ = 33, φ = 0.7450, ε = 0.6706, µ = 0.8730)

25

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