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Subsidies for Green Technology: The Role of Competition and Flexibility

by Fiona Paine on Tuesday May 12, 2015

The effects of government policies on green technology diffusion have become an increasingly important research area in recent years. Countries have been passing different types of incentives to encourage the adoption of green technology, but their effectiveness and cost depend on a variety of factors. Two recent working papers co-authored by Georgia Perakis, the William F. Pounds Professor of Operations Research at the MIT Sloan School of Management and an affiliate of CEEPR (see profile in this newsletter) examine such factors by addressing the role of competition and flexibility in the application of green technology subsidies.

In the first paper, titled “Competition and Externalities in Green Technology Adoption”, Perakis and her co-authors study the effect of competition in markets for green technology among multiple suppliers under the influence of government subsidies. As they show, the effects of competition depend on demand uncertainty, the type of competition, and the level of externalities in the market. To analyze and better understand the impact of subsidies, the research team creates a model and tests its findings with data from the increasingly competitive electric vehicle industry.

The electric vehicle market offers a good case study: Consumers who buy electrical vehicles are offered a federal tax rebate of up to $7,500, a consumer subsidy that has been in effect since December 2010 and affords consumers the option to choose between different cars, creating competition. The model takes into account both demand uncertainty and positive externalities in different competitive scenarios. In this context, externalities refer to the monetary value of the CO2 reduction from switching to an electric vehicle, or more generally the benefit to the environment of green technology use.

Specifically, the paper found that in a market with smaller externalities, suppliers are worse off from competition while the government benefits. Competition thus allows the government to reduce its expenditures by decreasing rebates while suppliers have a lower expected profit. When externalities are large, however, consumers are always better off from competition: Competition results in larger available quantities and lower effective prices for customers. 

Which party benefits from competition does not solely depend on the level of the externality: demand uncertainty and supplier asymmetry also play a role. When demand is deterministic and suppliers are identical, the entire benefit is absorbed by the government, meaning consumers are not impacted by competition. With asymmetric competition, by contrast, consumers share some of the benefit of competition with the government. Regardless, demand uncertainty always works in favor of customers.

Government subsidies for green technology are also studies in the second paper, titled “Consumer Subsidies with a Strategic Supplier: Commitment vs. Flexibility”. In that paper, Perakis and a team of co-authors investigate the effect of policy shifts over time on industry production decisions. They develop a model based on two-period games with uncertain demand to gain insight into the interaction between the government and an industry player, and test the model with data from solar subsidy programs. In Germany, where a flexible policy framework is in place, the feed-in-tariff incentivizing solar technology deployment was changed four times in 2012 alone. This contrasts with the US, where the subsidy of $7,500 for consumers purchasing electric vehicles has stayed constant since 2010.

As the paper shows, the commitment of a government along with the timing of policy decisions has an impact on industry. By anticipating a policy change, a supplier might actually decrease production targets, thereby increasing the cost of the subsidy program. A fixed policy commitment enables industry to have higher production earlier on the time horizon and thus is (on average) a cheaper option than a flexible subsidy policy; the exception is when there is negative demand correlation across time periods. At the same time, the flexible policy scenario causes lower variance in total sales, probably due to the fact that additional spending can reduce uncertainty at the adoption level for green technology. In addition, the supplier actually has a higher expected profit with flexible subsidies, whereas consumer benefits from policy changes depend on the price elasticity of demand.

A better understanding of the effects of subsidies on the green technology market is critical to help governments design better and more efficient policy, making this an area that warrants further research.

1Maxime C. Cohen, Georgia Perakis, and Charles Thraves (2015), “Competition and Externalities in Green Technology Adoption.” CEEPR WP-2015-007, MIT, May 2015.
2Jonathan Chemama, Maxime C. Cohen, Rubel Lobel, and Georgia Perakis (2015), “Consumer Subsidies with a Strategic Supplier: Commitment vs. Flexibility.” CEEPR WP-2015-008, MIT, May 2015