When should governments intervene to promote specific types of productive activity? Nowhere has this question been more vigorous debated than in the commercial aerospace industry, where production has been supported and encouraged in both covert or overt ways by governments around the world. Many reasons can be imagined for the favoured status of aerospace, from the cynical (‘politicians like shiny toys’) to those more firmly grounded in an analysis of market failure.

There are persuasive grounds for thinking that aerospace is likely to be subject to market failures, notably large scale economies in production and the importance of research and development. Such market failures are often difficult for individual countries to overcome on their own. As a result, aerospace has given rise to significant international cooperation.

The most celebrated instance of such cooperation is the European Airbus consortium, formed in the late 1960s to challenge the dominance of the Boeing Corporation in world markets. Its rivalry with Boeing and another American firm, McDonnell-Douglas (MDD), has led to fierce claims about the role of public funding in generating ‘unfair’ competition.

The idea that governments can affect the credibility and success of market entry was in vogue in the mid-1980s with the development of ‘strategic trade theory’. According to this view, governments give credibility to entry by committing to absorb whatever losses occur. Provision of finance for fixed development costs signal this intention.

Such schemes were the key element of public support for Airbus. Faced with guaranteed entry, Airbus’s competitors would presumably alter their competitive strategies, including pricing and product developments. In particular, government support for the A-320 programme is thought to have induced Boeing to produce a new version of the 737 in the market for narrow-bodied, short-range aircraft. In the absence of guaranteed competition, Boeing might instead have developed a completely new aircraft for that market.

Similarly, support for the A330/340 programme was thought likely to deter a very aggressive response to Airbus from Boeing. It was also expected to deter MDD from development of a long-range, medium-bodied aircraft, especially after its highly visible hesitation about whether to continue in civil aerospace at all. In the event, in spite of Airbus, MDD went ahead with the development of the MD-11, now in production.

A recent paper by Damien Neven and Paul Seabright attempts to estimate the impact of Airbus on the market for large commercial airliners, identifying the costs and benefits of setting up the consortium. This exercise highlights the consequences of European public support for Airbus to the extent that, in the absence of government support, the Airbus project would not have flown at all.

Neven and Seabright model the development of the market as a multi-stage game with three players: Boeing, MDD and Airbus. A number of striking conclusions emerge from their simulations.

First, given the prior presence of MDD, Airbus had only a modest impact on the prices of commercial airliners - on average 3.5%. Although the presence of Airbus constrained Boeing, it weakened MDD’s incentive to compete vigorously with Boeing; and, by reducing Boeing's market share, prevented the realization of substantial economies of scale and scope.

This means that the argument that subsidies to Airbus would generate consumer surplus benefits is only weakly supported. But Airbus is still a more effective competitor for Boeing than MDD: prices in a market with only Boeing and MDD would on average be 2% higher than in a market with only Boeing and Airbus. This is principally because MDD’s aircraft have significantly higher running costs than those of Airbus. Furthermore, if MDD had not been present in this market, a Boeing monopoly would have had dramatically higher prices - 15% on average. So consumer surplus benefits from the challenge to Boeing have certainly been substantial – though most of them could have been achieved by MDD alone.

Neven and Seabright’s second conclusion is that the impact of Airbus on overall technological innovation in the industry has been negative. Airbus’s entry lowered Boeing and MDD’s expected production runs and thereby reduced the profitability of investment in efficiency in fuel and maintenance. Aggregate R & D in the industry has risen, but there has been greater duplication.

The third effect is that Airbus’s presence reduces Boeing's profits by at least $100 billion and MDD's by about two-thirds. Airbus itself makes profits that probably lie between $40-52 billion, or around one billion dollars a year. This is equivalent to a rate of return over the whole period of between 6-11%. If profits and consumer surplus are given the same weight, Airbus has had a large negative impact on world social welfare but a comfortably positive impact on European welfare.

Lastly, Neven and Seabright assess the impact of Airbus’s guaranteed entry on the entry decisions of the other producers. Although Airbus may have deterred MDD from producing aircraft in the same category as the A300 (medium-range, medium-bodied), it may actually have made it easier for MDD to produce the MD-11 in competition with the A330/340 and the Boeing 777. The loss of scale and scope economies by Boeing as a result of Airbus’s entry substantially raised Boeing’s costs in producing the 777, making entry more attractive for MDD even when Airbus's presence is taken into account.

Overall, Neven and Seabright’s results suggest that the external benefits from the entry of Airbus into the market, though positive, have been modest. This suggests that government support for the Airbus consortium will have been justified primarily if Airbus proves to have been profitable. There is a reasonable chance this will be the case.

This article reviews research reported in ‘European Industrial Policy: The Airbus Case’ by Damien Neven and Paul Seabright, published in Economic Policy 21 (October 1995). Neven is Professor of Economics at the Universite de Lausanne and a Programme Director of CEPR’s Industrial Organization programme; Seabright is a Fellow of Churchill College, Cambridge and a Research Fellow in CEPR’s Industrial Organization programme. The paper draws on a simulation study commissioned by the UK Department of Trade and Industry.