Without any subsidies, firms AA and BB can choose whether to produce or not. This interaction of the two will lead to a certain matrix of costs and benefits, developed in a hypothetical example below. This analysis is based on Nash’s development of game theory. (Figures in bold and italics represent AA’s positions.)
The first firm that decides to produce will dictate the other producer’s decision.
In this case, if BB decides to produce with this cost advantage, it will always lead AA to choose the option BB produces/AA does not produce, if AA does not want to suffer a loss. In this case, BB has to produce because this strategy always results in a gain for BB superior or equal to zero.
How can this balance be changed? The next question for the policy-maker in country A, where AA is located, would be to support AA’s production by granting a subsidy to AA (if AA decides to produce). To demonstrate the change, let us assume that AA receives a subsidy of, for example €30 million.
Firm AA will produce anyway in this case, because its gain is always positive. Therefore, BB has no interest in entering the market because its profit is zero if firm AA produces. Despite the fact that BB has a cost advantage, BB is sure to obtain a zero gain, since AA has an incentive to produce, whatever BB’s decision. The subsidy for AA thus affects BB’s production exports to country A and therefore market competition, since it protects a domestic producer; BB faces a deterrent effect. One of the possible consequences of this subsidy policy would be rising prices in the domestic markets of company AA. Subsidies can be also interpreted as posing a trade barrier to BB’s products.