“Welcome, Europe. Glad you’re here now.” tweeted Jennifer Harris, a former White House advisor and co-author of the renowned book War by Other Means, when the European Commission announced an investigation into subsidized Chinese electric vehicle exports. Cars produced in China still only account for a very small part of all car sales in the EU, but in the electric segment China is on its way to double its market share in the next two years. I will argue why the EU is right to be worried about Chinese subsidies.

According to classical trade theories the subsidies make little sense from the Chinese perspective and should not give the EU reason to worry. The Chinese government is subsidizing a product that will end up abroad. Funds that could have gone to local hospitals or schools are used to lower the price for foreign consumers. As the EU is trying to decrease its carbon footprint and the subsidies will reduce the price of European electric vehicle imports, one could argue that the EU should welcome the Chinese subsidies.

Yet, the conclusions of classical trade theories are not infallible. In the ‘80s some trade theorists[1] abandoned the assumption that international markets are competitive and considered the consequences of a market that would be dominated by just a handful of producers. If the production of a good only becomes profitable if it is produced in very high quantities, a firm might only be profitable if it is the sole global producer. The typical example is the market for airplanes where Boeing and Airbus produce the same planes and there is not enough worldwide demand for both firms to be profitable. The EU could give Airbus subsidies to export planes. In this case, it would be profitable for Airbus to produce planes even if Boeing produces similar planes, but it would not be profitable for Boeing to compete without subsidies. Boeing would reason that competing with Airbus is futile and stop its activities, leaving a very profitable market to Airbus. The profit of Airbus could offset the costs of the subsidy for the EU. The new trade theories or strategic[2] trade theories thus show that export subsidies can increase the wealth of the domestic economy.

One of the difficulties with the new theories is that the conclusions are only valid under strict conditions, and it is hard for policymakers to verify if the conditions are met. The market for the good must have high barriers to entry and the production process should enjoy economies of scale. Making one airplane is expensive, as the firm pays for all the research that goes into the technology to make it fly. Making the second plane will be less expensive, as the firm already did the research. In the end, the firm that makes lots of planes will be able to offer the planes at a lower price than the firm that only produces a couple, because the R&D costs are spread out over all the planes. Another condition is that the goods on which the firms compete are absolute substitutes, meaning that the users will be indifferent between the two suppliers. The planes of the two constructors have similar technology and capacity, and most passengers are even not aware if they are flying in a European or an American plane.

Even for experts it is often difficult to grasp the complex and ever-changing characteristics of a hi-tech industry. Yet it can be argued that electric vehicle production has high barriers to entry. Anyone who wants to start an electric vehicle plant must have a lot of patience and even more funds. The technology underlying electric vehicle production is cutting edge, so new entrants would have to make enormous investments in R&D if they want to compete. The traditional car industry turned out consolidated, with a handful of producers controlling the world market. The substitution condition is harder to verify. Chinese electric cars are cheaper, but less luxurious than their European counterparts, such as Mercedes and BMW, and therefore seem to serve a different market segment.

If other countries financially support producers to the same extent, we will spiral into a subsidy war where no country wants to scrap its subsidies so as not to leave the valuable industry to other countries. The profits of the producers will be low or non-existent and not make up for the costly subsidies in this scenario. The worldwide price of electric cars will be lower, but only because the subsidizing governments pay for the difference.

Even if the strategic trade theories might not be applicable to the case at hand or lead to a subsidy war, the subsidies could give China other strategic advantages as the production of a high-tech product brings along beneficial side effects. First, there could be technical E that increase technological know-how and productivity in adjacent sectors. Electric car production could lead to technical breakthroughs in the manufacturing of batteries, for example. Second, the production of electric vehicles could carry strategic clout. A good that is expensive to design from scratch and is important for the functioning of a society can be used by the exporting country for political ends. The EU is trying to make the transition to greener transportation, but its citizens are hard to wane of the comfort of the car. If the EU would be dependent on electric vehicle imports, it might be willing to make concessions on foreign policy to the exporting country to ensure continued supply.

Strategic trade theories have demonstrated that Chinese subsidies could make its industry push ahead and become profitable in the future at the expense of non-subsidised competitors. But even if the conclusions do not entirely hold, technical spill-overs and the strategic importance of the electric vehicle industry provide reasons for the EU to take heed of Jennifer Harris’ words and ensure a level-playing-field for European electric vehicle producers.

[1] Credit goes to James Brander and Barbara Spencer, on whose academic work the reasoning in this paragraph is based.

[2] Strategic refers to the behaviour of the firms that react to the decision of their competitor, and not to the military or geopolitical character of the goods.