Saturday, 9 December 2023

How much is enough? Government subsidies in supporting green product development

                       


European Journal of Operational Research

Volume 309, Issue 3, 16 September 2023, Pages 1316-1333



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https://doi.org/10.1016/j.ejor.2023.02.011Ge

Abstract

This paper tackles the problem of a monopolist firm that is considering designing products with environmental qualities while facing significant research and development costs. A mathematical formulation is adopted to model the impact of government subsidy on the firm's choice between mass marketing, where only one standard product serves the entire market, and market segmentation, in which the firm develops ordinary and green products for two market segments. The firm's behavior in reaction to the subsidies is analyzed through a two-stage Stackelberg game. The obtained results reveal that the subsidy level does not affect the relationships between the environmental qualities of the manufactured products under different marketing strategies when the green market is not strong. Our analyses also demonstrate how an optimal subsidy level should be selected to maximize the social welfare, and how this optimal subsidy is impacted by various parameters such as the magnitude of the development cost.

Introduction

During the last two decades, firms have shown a greater willingness to spend money on developing green products for the positive environmental impact and also the potential to improve the firm's reputation (Miles & Covin, 2000; Fraj-Andrés et al., 2009; Leonidou et al., 2013). However, it has been observed that some firms are still hesitant to develop green products due to barriers such as: the extensive research and development costs and the high risk of failure (Hafezi et al., 2023). This is evidenced by an online survey conducted by McKinsey, which reported that over 50 percent of 1946 executives pointed out they would consider environmental issues in many areas, such as green product development. However, due to the steep costs, only a small portion of them (almost 30%) were actively seeking opportunities to invest in green product development (McKinsey Survey, 2010).

For instance, since 1974, Japan has invested around $15 billion in hydrogen and fuel cells (Behling et al., 2015). However, it is unknown when this investment will start generating profit since firms are still unable to offer an effective and durable product at a reasonable price. While many researchers have been employed to improve the design of fuel cells in order to generate a more positive environmental impact, there is a remarkable need for additional investment in such technology.1 Therefore, given the existing challenges in developing green products, governments worldwide are using regulatory policies to incentivize firms to invest in producing environmentally friendly products. As a result, it is crucial that governments apply the best available regulatory mechanisms to encourage green product development. In what follows, we review some of these mechanisms, including the one that is the focal point of this study.

Many governments face the dilemma of trying to protect the environment while also endeavoring to stimulate and maintain economic growth. In response to these challenges, several worldwide ecological agreements have been born. A successful example is The Montreal Protocol, which was finalized by the United Nations in 1987 (Andersen et al., 2013). This protocol has already diminished 90% of ozone-depleting substances (ODSs) and it is expected to result in further improvements by 2060 if the countries continue to phase out the remaining ODSs.2 In addition to international agreements for environmental protection, many countries (e.g., Canada, China, and European countries) have enforced ecological regulations, also known as carrot-stick policies, such as taxes, cap-and-trade systems, carbon labeling, consumer rebates, and subsidies (e.g., Waide, 1998; Vine et al., 2001; Waide, 2001; Xunpeng, 2010; Krass et al., 2013; Andersen et al., 2013; Du et al., 2016; Drake et al., 2016; Li & Li, 2017; Luo et al., 2021). Some of these policies (e.g., taxes) penalize the firms whose products or processes harm the environment, while others (e.g., rebates) incentivize them to address environmental concerns (Galle, 2012; Dou & Choi, 2021). Depending on the characteristics of the problem under investigation, governments incorporate these policies either individually (Zhang et al., 2012; Gouda et al., 2016; Zhao & Chen, 2019; Wang & Wang, 2022) or together (Conrad, 2005; Ghosh et al., 2020). The studies investigating the impact of stick policies often target the environmental damage that results from the product or the process (Kroes et al., 2012; Gong & Zhou, 2013). On the other hand, some research focuses on carrot policies, such as government subsidies, to assess how firms can be motivated to participate in green practices (Li & Li, 2017; Shao et al., 2017). In addition, those who consider both tools often do not apply them on a single dimension (Bian & Zhao, 2020).

One of the common carrot policies is to subsidize green products (e.g., either through rebates or tax credits), which can be given to consumers in order to enhance their purchasing power and incentivize green choices. For instance, Canada's Energy Savings Rebate program provides approximately CAD 200 million to eligible Ontarian retailors so that they can offer up to a 25% sales rebate to consumers who purchase qualified energy-efficient appliances in 2019 and 2020.3 A similar way to encourage consumers is to offer a tax credit for purchasing a green product. Since the prices of green products are often higher than ordinary ones, a tax credit per product sold helps to fill the gap between the purchase price of the green products and the consumer's willingness to pay. For example, to motivate firms to produce more electric vehicles, the American Authority provides a subsidy so that they can offer consumers a tax credit of up to $7500 when they purchase a new electric vehicle. This tax credit is accessible to every firm for the first 200,000 qualifying electric vehicles they sell in the US.4

A government's financial support can also be used to encourage firms to invest more in the research and development of green products with higher environmental quality. This type of support is common in practice and is being implemented worldwide. In this situation, the creation of each unit of environmental attributes of products is usually valued due to its potential positive impact on the environment and social welfare in general. For instance, this could be manufacturing energy-efficient vehicles based on internal combustion engines (Lou et al., 2020) or improving new energy vehicles, such as enhancing the performance of electric-driving components of electric vehicles (Zhang & Huang, 2021). The Automotive Innovation Fund (AIF) in Canada (launched in 2008) is one practical example of this kind of support. The fund supported the research and development costs of ten projects between 2008 and 2017. A large portion of this fund ($569.8 million) was assigned to five automakers (Toyota, Honda, Ford, Linamar, and Magna) in an aim to produce products with higher environmental quality such as energy (fuel) efficient vehicles. The government of Canada confirms that the AIF has had a significant impact on reducing negative environmental consequences,5 e.g., reducing greenhouse gas emissions (Buekers et al., 2014).

Another well-known term is new energy vehicles (NEVs). This term has been promoted extensively in China, with government support, especially through the “Energy-Saving and New Energy Vehicles Industry Development Program (2012–2020)”. In support of NEVs, different levels of the Chinese government, including the national and local authorities, have invested nearly $58.3 billion in this program between 2009 and 2017. Although the majority of such support ($36.6 billion) was aimed at consumers in the form of discounted prices, a large amount of the funding was also poured into research and development for approved manufacturers.6 As stated by the Chinese Ministry of Industry, this support did not change significantly in 2020 (Reuters, 2020). Therefore, in this study, we follow the common approach in practice and the literature (e.g., Zhang et al., 2012; Yu et al., 2016; Li et al., 2020) in which any research and development effort in protecting the environment is rewarded and not penalized.

Our above discussions illustrate several examples that show how government subsidies can play a positive role in developing and promoting green products and sustainable technologies. However, there are many situations where government subsidies are very limited and inadequate. Moreover, there are situations where the government does not offer any subsidy schemes, or if it does, these policies are inconsistent, unpredictable, and poorly implemented. Kannan et al. (2022) recently identified several challenges toward the green transition through a systematic review of the literature. The authors reported that a lack of government funding and inconsistent regulations and policies as significant barriers to developing green products and sustainable technologies. For instance, it has been shown that limited subsidies such as small grants or incremental tax credits are not effective (OECD, 2006; Stevens, 2010). In addition, several empirical studies (e.g., in New Zealand by Barry and Chapman (2009); in the Kingdom of Bahrain by Dutta (2015); in the European Union by Ghisetti et al. (2015), and in Saudi Arabia by Chien et al. (2022)) also discuss the importance of sufficient government supports for green product development and utilizing green technologies.

In an empirical study conducted in Indonesia, Setyawat (2020) explained that the government does not offer any subsidy scheme to support and promote solar technology for private use. Although not having any subsidy policy is considered a barrier, inconsistent and unpredictable policies can remove firms’ incentives to invest in environmental innovation and create many uncertainties (Ghisetti et al., 2015). Sawin (2004) argued that on-and-off policies resulted in suspended projects and lay-offs in the U.S. and Denmark. An example of how unpredictable policy leads to uncertainty can also be observed in the sale of electric vehicles in Ontario, Canada. The sales in Ontario dropped by more than half in the first six months of 2019 compared to the same period in 2018, which can be explained by the cancelation of the rebate program shortly after the progressive conservative government was elected.

As exemplified by the cases above, government subsidies do not widely exist, or if they do, they do not automatically encourage firms to participate in green product development. The subsidies should also be adequate, consistent, and properly implemented to be effective. Therefore, one practical question that the government bodies are facing is:

  • ■

    How can governments set their subsidy levels to encourage profit-maximizing firms to invest in green product development while improving total social welfare?

Addressing the above research question is an essential step in extending the literature on green product development. It is also worth mentioning that although one of the main intentions of imposing regulations is to protect the environment, the overall impact on all stakeholders is what the government is most concerned about (Zhao et al., 2018). For example, Hafezi and Zolfagharinia (2018) demonstrated that environmental regulations that were too strict can make firms reluctant to innovate, and may have an adverse economic impact. That is why the literature concludes that governments should take a more moderate approach in setting environmental policies to balance consumers’ benefits and environmental benefits where the impact on firms is addressed (e.g., Wang et al., 2021). Therefore, in setting the regulations, the subsidy is targeted at a level to maximize the aggregate impact on social benefits while minimizing government expenditures (Skerlos et al., 2010). Recently, more studies have adopted this holistic approach to investigate the role of government in the development of green products (e.g., Li & Li, 2017; Wang & Wang, 2022).

Therefore, in this work, we also take a comprehensive view by considering different aspects of social welfare, such as the firm's profit, consumer surplus, government expenses, and environmental impacts (Wang et al., 2021). We then employ a two-stage Stackelberg game theory approach where the government sets its subsidy level to maximize social welfare considering a profit-oriented firm that decides on the price and environmental quality of its products. By analyzing the proposed model, we are able to suggest the optimal subsidy level for the government to use to incentivize the firm to develop green products while also maximizing social welfare.

The remainder of this study is organized as follows: in Section 2, we review relevant studies to highlight the contributions and novelty of our work. In Section 3, the problem is defined, and its underlying assumptions are discussed. In Section 4, we formulate the mathematical model for two marketing strategies. In addition, the optimal subsidy levels are determined for each marketing strategy, and the effects of the parameters on the optimal subsidies are analyzed. In Section 5, the impact of government subsidies on the prices and environmental quality of the products is investigated in detail. Then, in Section 6, we investigate the effect of government subsidies on both firms’ marketing strategies and the total social welfare. Lastly, we conclude with a summary of managerial insights and propose some areas for future research.

Section snippets

Literature review

Over the last few years, problems related to the impact of government regulations on the production and development of green products have received a remarkable amount of attention. Saberi et al. (2018) believe that to reduce negative environmental effects, regulators should design policies that encourage firms to invest in environmentally friendly products, or they should penalize companies that do not invest in the production of green products. They discussed multiple practical tools in this

Problem definition

We consider a monopoly firm producing a durable product with traditional quality x and environmental quality y. Since a durable product does not need to be purchased frequently, we assume that the purchase cannot be repeated. Therefore, each consumer buys only one unit of the product, regardless of its type, which has been an assumption commonly used in the literature (e.g., Chen, 2001; Jing, 2011; Zhang et al., 2017; Hafezi & Zolfagharinia, 2018). Consumers will select products based on their

Formulating marketing strategies

In this section, we introduce the parameters, notations, and decision variables as shown in Table 2, Table 3, Table 4. We also briefly review the Stackelberg game, which helps analyze the problem under investigation. Then, we formulate the mathematical model for both marketing strategies (i.e., the mass marketing and market segmentation strategies) to find the optimal subsidy level. Finally, we will examine the impact of changes in the green consumers' preference for environmental quality, the

The impact of government subsidies

We will now analyze how the optimal subsidy level affects prices of the products, along with the firm's profits, in both marketing strategies.

Proposition 7

  • (i)

    The traditional quality level of standard, ordinary, and green products, i.e., xs,xo and xg do not change by increasing the subsidy level θ.

  • (ii)

    The environmental quality level of standard, ordinary, and green products, i.e., ys,yo and yg increase by increasing the θ value.

Proof

The proof to follow is provided in Appendix A.7.

The results of Proposition 7 are to be

The optimal government subsidy

Although the provided subsidy costs the government, it can positively impact three other dimensions: the firm's profitability, the surplus of green consumers, and the environment. Therefore, when the subsidy is provided on each unit of the environmental quality regardless of the overall environmental attributes of the product (e.g., ys), we observe that the optimal subsidies are positive for both marketing strategies (i.e., refer to the results of Propositions 2 & 4). This infers that offering

Conclusions, implications, and future research directions

Environmental regulations and their effects on green product development have become a critical challenge for governments. Although subsidies are often considered as effective tools to encourage firms to develop green products by supporting the related research and development costs, governments need to set subsidy levels strategically to improve social welfare. In this study, we adopted a two-stage Stackelberg game to analyze the effects of government subsidies on firm's marketing strategies,

Acknowledgments

Authors would like to express their appreciation to the Social Sciences and Humanities Research Council (SSHRC) of Canada through an Insight Development Grant (#430–2018–0340).

References (111)

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