Boeing versus Airbus: Two Decades of Trade Disputes1
1The following PBS video is recommended to accompany this case: http://pbs-newshour.virage.com/cgi-bin/visearch?squery=+ClipID:5++VideoAsset:pbsnh053105&query=Trade&user=pbs-newshour&tid=email
For decades the commercial aircraft industry has been an American success story. Until 1980, U.S. manufacturers held a virtual monopoly in the field. Despite the rise of the European-based Airbus Industrie, this dominance persisted to the mid-1990s, when two U.S. firms, Boeing and McDonnell Douglas, accounted for over two-thirds of world market share. In late 1996, many analysts thought that U.S. dominance in this industry would be further strengthened when Boeing announced a decision to acquire McDonnell Douglas for $13.3 billion, creating an aerospace behemoth nearly twice the size of its nearest competitor.
The industry is routinely the largest net contributor to the U.S. balance of trade, and Boeing is the largest U.S. exporter. The U.S. commercial aircraft industry has regularly run a substantial positive trade balance with the rest of the world of $12 to $15 billion per year. The impact of the industry on U.S. employment is also enormous. Boeing directly employs some 57,000 people in the Seattle area alone, and another 100,000 elsewhere in the nation. The company also indirectly supported a further 600,000 jobs nationwide in related industries (e.g., subcontractors) and through the impact of Boeing wages on the general level of economic activity.
Despite Boeing’s formidable reach, since the mid-1980s U.S. dominance in the commercial aerospace industry has been threatened by the rise of Airbus Industrie. Founded in 1970, Airbus began as a consortium of four European aircraft manufacturers: one British (20.0 percent ownership stake), one French (37.9 percent ownership), one German (37.9 percent ownership), and one Spanish (4.2 percent ownership). Airbus was initially a marginal competitor and was regarded as unlikely to challenge U.S. dominance. Since 1981, however, Airbus has confounded its critics by progressively gaining market share. By the early 2000s Airbus was consistently gaining a larger share of new orders than Boeing, and in 2003 it surpassed Boeing for the first time in deliveries of aircraft, with 305 deliveries against Boeing’s 281. Also, in the early 2000s Airbus made the transition from a consortium to a fully functioning private entity, and it is now a division of the European Aeronautic Defense and Space Company (EADS).
Over the years, many in the United States have responded to the success of Airbus by crying foul. U.S critics repeatedly claim that the governments of Great Britain, France, Germany, and Spain heavily subsidize Airbus. Airbus has responded by pointing out that both Boeing and McDonnell Douglas have benefited for years from hidden U.S. government subsidies. In 1992, the two sides appeared to reach an agreement that put to rest their long-standing trade dispute. The agreement allowed Airbus to receive some launch aid from EU governments and Boeing to benefit from government R&D contracts. However, the dispute broke out again in 1997, when the European Union decided to challenge the merger between Boeing and McDonnell Douglas on the grounds that it limited competition. Although that dispute was settled, trade tensions erupted yet again in 2004 when the United States charged that given Airbus’s success in the marketplace, the launch aid that was allowed under the 1992 agreement was no longer appropriate. Airbus responded with accusations that Boeing was still benefiting from subsidies. When negotiations between the United States and EU over this dispute broke down in early 2005, Boeing referred the dispute to the World Trade Organization. This case reviews the history of these trade disputes.
Industry Competitive Dynamics
Competitive dynamics in the commercial aircraft industry are driven by a number of key factors. Perhaps foremost among these is that the costs of developing a new airliner are enormous. Boeing spent a reported $5 billion developing and tooling up to produce the 777 wide-bodied jetliner that it introduced in 1994. The development costs for Airbus’s most recent aircraft, the 555-seat A380 “super-jumbo,” which is scheduled to enter service in 2006, are estimated to be anywhere between $10 billion and $15 billion. (The A380 is a direct competitor to Boeing’s profitable 747 model line.) Similarly, development costs for Boeing’s newest offering, the “super efficient” 787 that will enter service in 2008, are estimated to be in the $7 to $8 billion range.
Given such enormous development costs, a company must capture a significant share of world demand to break even. In the case of the 777, for example, Boeing needed to sell more than 200 aircraft to break even, a figure that represented about 15 percent of predicted industry sales for this class of aircraft between 1994 and 2004. Given the volume of sales required to break even, it can take up to 10 to 14 years of production for an aircraft model to turn a profit and this on top of the 5 to 6 years of negative cash flows during development.
On the manufacturing side, a significant experience curve exists in aircraft production. Due to learning effects, on average, unit cost falls by about 20 percent with each doubling of accumulated output. A company that fails to move along the experience curve faces a significant unit-cost disadvantage. A company that achieves only half of the market share required to break even will suffer a 20 percent unit-cost disadvantage.
Another feature of the industry is that demand for aircraft is highly volatile. This makes long-run planning difficult and raises the risks involved in producing aircraft. The commercial airline business is prone to boom-and-bust cycles. During the early 1990s, and then again in the early 2000s, the major airlines suffered from falling demand and high fuel costs, and many major carriers entered bankruptcy. Orders for aircraft tend to follow these cycles, with order volumes in strong years frequently being two to three times as large as in weak years.
The combination of high development costs, breakeven levels that constitute a significant percentage of world demand, substantial experience curve levels, and volatile demand makes for an industry that can support only a few major players. Analysts seem to agree that the large jet commercial aircraft market can profitably support only two, or possibly three, major producers. By the early 2000s there were only two major players in the industry, McDonnell Douglas having been absorbed by Boeing. This, combined with the strong production and order levels reached that year, should have boded well for productivity. However, Boeing’s profits were poor during the late 1990s and early 2000s as it struggled to cope with a poorly managed ramp-up of its aircraft production rates, the effects of unexpectedly high manufacturing costs, and intense price competition from an increasingly aggressive Airbus.
Trade Frictions Before 1992
In the 1980s and early 1990s, both Boeing and McDonnell Douglas argued that Airbus had an unfair competitive advantage due to the level of subsidy it received from the governments of Great Britain, France, Germany, and Spain. They argued that the subsidies allow Airbus to set unrealistically low prices, offer concessions and attractive financing terms to airlines, write off development costs, and use state-owned airlines to obtain orders. In making these claims, Boeing and McDonnell Douglas had the support of the U.S. government. According to a study by the Department of Commerce, Airbus received more than $13.5 billion in government subsidies between 1970 and 1990 ($25.9 billion if commercial interest rates are applied). Most of these subsidies were in the form of loans at below-market interest rates and tax breaks. The subsidies financed research and development and provided attractive financing terms for Airbus’s customers. For most of its customers, Airbus is believed to have financed 80 percent of the cost of aircraft for a term of 8 to 10 years at an annual interest rate of approximately 7 percent. In contrast, the U.S. Export-Import Bank required 20 percent down payments from Boeing and McDonnell Douglas customers, financed only 40 percent of the cost of an aircraft directly, and guaranteed the financing of the remaining 40 percent by private banks at an average interest rate of 8.4 percent to 8.5 percent for a period of 10 years.
Airbus’s response to these charges was to point out that its success was not due to subsidies but to a good product and a good strategy. Most observers agree that Airbus’s aircraft incorporate state-of-the-art technology, particularly in materials applications, systems for flight control and safety, and aerodynamics. Airbus gained ground initially by targeting market segments not served by new aircraft or not served at all. Thus, Airbus took the initiative in targeting two segments of the market with wide-bodied twin-engine aircraft, then in developing a new generation of aircraft for the 150-seat market, and next, going after the market below the 747 for a 250- to 300-seat airliner with its A330 and A340 models (to which Boeing’s 777 was a belated but apparently successful competitive response).
Airbus also argued that both Boeing and McDonnell Douglas benefited from U.S. government aid for a long time and that the aid it has received has merely leveled the playing field. In the United States, planes were built under government contract during World War I, and the construction of mail planes was subsidized between the world wars. Almost all production was subsidized during World War II, and subsidies continued at a high level after the war. The Boeing 707, for example, is a derivative of a military transport program that was subsidized by the U.S. government. Boeing’s subsidized programs include the B-17, B-29, B-47, B-52, and K-135, just to name a few. Its nonairline programs have included the Minuteman missile, Apollo-Saturn, and space station programs.
A 1991 European Commission study attempted to estimate the amount of subsidies the U.S. industry received. The study contended that Boeing and McDonnell Douglas received $18 billion to $22 billion in indirect government aid between 1976 and 1990. The report claimed that commercial aircraft operations benefited through Defense Department contracts by as much as $6.34 billion during the 1976-1990 period. In addition, the report claims that NASA has pumped at least $8 billion into commercial aircraft production over the same period, and that tax exemptions gave an additional $1.7 billion to Boeing and $1.4 billion to McDonnell Douglas.
Boeing rejected the claims of the European Commission report. The company pointed out that the report’s assumption that Boeing receives direct government grants in the form of an additional 5 percent for commercial work with every military or space contract it receives was false. Moreover, the company argued that during the 1980s only 3 percent of Boeing’s R&D spending came from Department of Defense funding and only 4 percent from NASA funding. Boeing also argued that since the four companies in the Airbus consortium do twice as much military and space work as Boeing, they must receive much larger indirect subsidies.
The 1992 Agreement
In mid-1992, the United States and the four European governments involved agreed to a pact that many thought would end the long-standing dispute. The 1992 pact, which was negotiated by the European Union on behalf of the four member states, limited direct government subsidies to 33 percent of the total costs of developing a new aircraft and specified that such subsidies had to be repaid with interest within 17 years. The agreement also limited indirect subsidies, such as government-supported military research that has applications to commercial aircraft, to 3 percent of a country’s annual total commercial aerospace revenues, or 4 percent of commercial aircraft revenues of any single company in that country. Although Airbus officials stated that the controversy had now been resolved, Boeing officials argued that they would still be competing for years against subsidized products.
In February 1993, it looked as if the trade dispute was about to reemerge. The newly elected President Clinton repeatedly blasted the European Union for allowing subsidies of Airbus to continue, blamed job losses in the U.S. aerospace industry on the subsidies, and called for the EU to renegotiate the 1992 deal.
To the surprise of the administration, however, this renewed attack on Airbus subsidies was greeted with conspicuous silence from the U.S. industry. Many analysts theorized that this was because a renewed dispute could prompt damaging retaliation from Europe. For one thing, Airbus equips its aircraft with engines made by two U.S. companies-Pratt & Whitney and General Electric-and with avionics made by U.S. companies. In addition, many state-owned airlines in Europe purchase aircraft from Boeing and McDonnell Douglas. Many in the U.S. industry apparently felt that this lucrative business would be put at risk if the government reopened the trade dispute so soon after the 1992 agreement.
A similar cool response from the U.S. industry greeted attempts by two U.S. senators, John C. Danforth of Missouri and Max Baucus of Montana, to reopen the trade dispute with Airbus. In early 1993, Danforth and Baucus cosponsored legislation requiring the U.S. government to launch a trade case against Airbus on charges of unfair subsidies. They also sponsored a bill to create an aerospace industry consortium called Aerotech that would finance aerospace research, with half of the funds coming from industry and half from the U.S. government. Vice President Al Gore called the establishment of Aerotech “an administration priority,” but a Boeing spokesman said the company was “very guarded about Aerotech” because it could violate the 1992 accord. Both Danforth/Baucus bills died in committee hearings, and the Clinton administration quietly dropped all talk of reopening the trade dispute.
The Boeing-Mcdonnell Douglas Merger
In December 1996, Boeing stunned the aerospace industry by announcing it would merge with longtime rival McDonnell Douglas in a deal estimated to be worth $13.3 billion. The merger, scheduled to be completed by the end of July 1997, was driven by Boeing’s desire to strengthen its presence in the defense and space side of the aerospace business areas where McDonnell Douglas was traditionally strong. On the commercial side of the aerospace business, Douglas had been losing market share since the 1970s. By 1996, Douglas accounted for less than 10 percent of production in the large commercial jet aircraft market and only 3 percent of new orders placed that year. The dearth of new orders meant that the long-term outlook for Douglas’s commercial business was increasingly murky. With or without the merger, many analysts felt that it was only a matter of time before McDonnell Douglas would be forced to exit from the commercial jet aircraft business. In their view, the merger with Boeing merely accelerated that process. Because the merger would reduce the number of players in the commercial aerospace industry from three to two, it was expected that the antitrust authorities would review the merger.
Boeing and McDonnell Douglas officials expected both the U.S. Federal Trade Commission (FTC) and the Competition Commission of the European Union to investigate the merger to assess its effects on competition. Boeing executives believed that the FTC would approve the proposed merger. Boeing’s argument was that the Boeing-McDonnell Douglas combination was necessary to create a strong U.S. competitor in a competitive global marketplace. This is an argument that U.S. antitrust authorities have been sympathetic to in recent years. Moreover, Boeing executives pointed out that since the end of the Cold War, the U.S. government had been arguing for consolidation in the defense industry to eliminate excess capacity. They argued that the Boeing-McDonnell Douglas merger helped to achieve that goal and thus should receive government support.
As for the Europeans, here too Boeing executives believed there would be little opposition to the merger. In the words of Harry Stonecipher, CEO of McDonnell Douglas, “My good friend Jean Pierson, head of Airbus, has been saying at air shows lately, ‘Douglas is not a factor in the commercial industry’ so the deal is apparently a non-event.” Initially, Airbus officials seemed to indicate they agreed with this assessment and would not oppose the merger. However, within days of the merger announcement, Karl Van Miert, the EU competition commissioner, signaled that the EU would launch a probe of the merger. Van Miert stated that the EU would oppose the merger if it thought doing so was necessary to preserve competition. In justifying the probe, he expressed the concern that if the number of players in the market for large commercial jet aircraft were reduced to two, they might engage in tacit collusion, raising prices above the level that would prevail in more competitive market situations.
Van Miert’s statements raised hackles in the United States. Government officials and Boeing executives were heard wondering out loud what authority a European body would have over a merger between two U.S. companies that did almost all their manufacturing in the United States and had few assets in Europe. Van Miert stated that EU law required him to evaluate the merger and entitled the EU to block the merger if it was found to be anticompetitive. While Van Miert acknowledged that the EU could not actually stop the merger, under EU competition law the commission could declare the merger illegal, restrict its business in Europe, and fine it up to 10 percent of its estimated $48 billion annual sales. Boeing executives argued that if this were the outcome, it would provoke a trade war between the United States and the EU. Some U.S. politicians claimed that the EU’s stance amounted to nothing less than a flagrant violation of U.S. national sovereignty.
Complicating the issue further was Boeing’s success in negotiating long-term exclusive supply contracts with three major U.S.-based airlines: American Airlines, Delta, and Continental. The American Airlines deal was signed in late 1996 and the two others in the first half of 1997. All three deals named Boeing the exclusive supplier of each airline’s aircraft needs for 20 years. Van Miert argued that these agreements were anticompetitive and reinforced his concerns about the market power of a Boeing-McDonnell Douglas combination. These agreements seemed to promote a change of heart among Airbus executives. After originally stating that they had no objections to the merger, Airbus executives became increasingly vocal in their opposition to it. In March 1997, Jean Pierson, the head of the consortium, warned that the proposed merger could give Boeing a “structural hold” on the industry, spanning the supply of aircraft, servicing, and spare parts. Similarly, commenting on the exclusive supplier deals, Airbus spokesman David Venz argued that the Boeing-McDonnell Douglas combination would “have a locked-in captive customer for 29 years. They have effectively removed choice from the airline who signs those contracts.”
In mid-May 1997, the European Commission gave Boeing and McDonnell Douglas its official statement of objections to the planned merger and asked the two U.S. groups to respond before June 12, when hearings on the subject were scheduled to take place in Brussels. The commission stated that the merger raised three principal concerns. First, it would restrict competition in the market for large commercial jet aircraft. Second, McDonnell Douglas’s extensive defense and space activities raised the possibility that U.S. government funding for defense and space programs would be used to fund the development of commercial jet aircraft. Third, the sole supplier agreements with American Airlines, Delta, and Continental restricted competition in the commercial aerospace market.
In commenting on these concerns, Boeing CEO Phil Condit noted that since McDonnell Douglas accounted for only 3 percent of commercial sales in 1996, one could hardly argue that the merger would have a restrictive effect on competition. Condit stated that there was no question of defense research funding being used for civil programs since the issue was already regulated by the 1992 bilateral trade agreement. As for the sole supplier agreements, Condit noted that the deals were struck at the initiative of the airlines.
On June 30, 1997, the Federal Trade Commission issued its own ruling on the merger. In a 4-to-1 decision, an FTC panel recommended that the merger be given unconditional approval. Before reaching its decision, the FTC interviewed 40 executives of airlines to find out whether they thought the merger would cause higher prices from Boeing. While some airlines expressed a preference that McDonnell Douglas remain in the bidding, they were virtually unanimous in acknowledging that they were unlikely to buy from that company because it appeared not to be making the investment required to remain viable. In short, the FTC concluded that McDonnell Douglas was no longer a viable competitor in the large commercial jet market, and therefore, the merger would not have a detrimental effect on competition. At the same time, the FTC did note that the sole supplier agreements that Boeing had reached were “potentially troubling.” Although the three agreements reached by July 1997 accounted for only 11 percent of the global market, the FTC signaled that it would be concerned if more occurred.
On July 18, senior EU officials stated publicly that they planned to declare the merger illegal, insisting that it would harm competition in Europe. In announcing this intention, Van Miert stated that he was particularly concerned about the exclusive supplier contracts, which unfairly closed Airbus out of an important segment of the global market.
In a last-minute bid to stop the European Commission from declaring the merger illegal, Boeing blinked and stated it would not enforce provisions in the 20-year supplier contracts with American, Delta, and Continental. With this concession in hand, on July 23, a triumphant Van Miert announced that the European Commission would now approve the merger. Across Europe, newspapers sang Van Miert’s praise, depicting him as the man who had defeated the American colossus. “You have to hand it to him,” stated one EU official, “he took them on and won. He showed them that the European Commission is a force to be reckoned with.”
Back to the Future: 2007
In the aftermath of the merger with McDonald Douglas, Boeing went through a period of financial turmoil, the result of congestion in its production system as the company tried to rapidly ramp up deliveries during the late 1990s. By 2002, however, Boeing was back on track and in 2003 it decided to go ahead and build its first new aircraft model in a decade, the 787. The 787, which will be offered in three versions and seat between 200 and 300 people, is to be built using composite materials and super-efficient jet engines that should reduce operating costs by 20 percent. The 787 is capable of flying up to 8,500 miles, making it ideal for long haul “point to point” flights. Boeing believes that as the volume of world air travel grows, more people will fly point to point, as opposed to through congested hubs. Estimates suggest that the new jet will cost some $7 to $8 billion to develop. A trio of three Japanese companies, Mitsubishi Heavy Industries, Kawasaki Heavy Industries, and Fuji Heavy Industries are building 35 percent of the 787 by value, including parts of the fuselage, wings, and landing gear. By July 2007 Boeing had amassed some 642 orders for the 787, a record order book for new planes, indicating strong demand. The first 787 planes are scheduled for delivery in 2008.
Meanwhile, Airbus was pushing ahead with the development of the 555-seat A380 super-jumbo jet. Designed to compete against the aging Boeing 747, the A380 is the largest commercial jet aircraft ever made. With development costs that may run above $15 billion, the A380 represents a huge bet by Airbus that passengers will continue to fly through hubs, rather than point to point as envisioned by Boeing. As of mid-2007, Airbus had some 150 orders for the A380. However, the rate of new orders had dried up as the A380 had become mired in production problems and the launch of the new aircraft had been delayed by nearly two years.
As Boeing started to garner more orders for the 787, however, Airbus began to wonder if it too should not hedge its bets and build a similar-sized super-efficient long-range aircraft capable of flying point to point. What raised a red flag in the United States was signs from Airbus that it would apply for $1.7 billion in launch aid to help fund the development of the A350. As far as the United States was concerned, this amount of aid was too much. In late 2004 U.S. Trade Representative Robert Zoellick issued a statement formally renouncing the 1992 agreement and calling for an end to launch subsidies. According to Zoellick, “since its creation 35 years ago, some Europeans have justified subsidies to Airbus as necessary to support an infant industry. If that rationalization were ever valid, its time has long passed. Airbus now sells more large civil aircraft than Boeing.” Zoellick went on to claim that Airbus has received some $3.7 billion in launch aid for the A380 plus another $2.8 billion in indirect subsidies, including $1.7 billion in taxpayer-funded infrastructure improvements, for a total of $6.5 billion.
Airbus shot back that Boeing too continued to enjoy lavish subsidies, and that the company had received some $12 billion from NASA for development technology, much of which has found its way into commercial jet aircraft. The Europeans also contended that Boeing would receive as much as $3.2 billion in tax breaks from Washington state, where the 787 is to be assembled, and more than $1 billion in loans from the Japanese government to three Japanese suppliers, who will build over one-third of the 787. Moreover, Airbus was quick to point out that a trade war would not benefit either side, and that Airbus purchased some $6 billion a year of supplies from companies in the United States.
In January 2005, both the United States and EU agreed to freeze direct subsidies to the two aircraft makers while talks continued. However, in May 2005 news reports suggested, and Airbus confirmed, that the jet maker had applied to four EU governments for launch aid for the A350 and that the British government would announce some $700 million in aid at the Paris Air Show in mid-2005. Simultaneously, the EU offered to cut launch aid for the A350 by 30 percent. Dissatisfied, the U.S. side decided that the talks were going nowhere, and on May 31 the United States formally filed a request with the World Trade Organization for the establishment of a dispute resolution panel to resolve the issues. The EU quickly responded, filing a countersuit with the WTO claiming that U.S. aid to Boeing exceeded the terms set out in the 1992 agreement. In early 2007 both sides presented their arguments to the World Trade Organization. The EU claimed Boeing was receiving lavish subsidies from federal, state, and local governments in the United States that will amount to $23.7 billion. For its part, Boeing argued that Airbus had received over $100 billion of aid from European governments over its lifetime if the loans it received at below-market interest rates are recalculated at commercial rates. A ruling from the WTO is not expected until mid-2008.
Case Discussion Questions
Do you believe Airbus could have become a viable competitor without subsidies?
Why do you think the four European governments agreed to subsidize the establishment of Airbus?
Is Airbus’s position with regard to the long-running dispute over subsidies reasonable?
Do you think that the 1992 trade agreement was reasonable?
Why do you think that the U.S. industry reacted with caution to attempts by politicians to reopen the trade dispute in 1993?
In an era of global competition, what is the case for antitrust authorities to permit the formation of large domestic firms through mergers and acquisitions?
Was the threat by EU authorities to declare the Boeing-McDonnell Douglas merger illegal a violation of U.S. national sovereignty?
Do you think the EU Commission had a strong case in its attempts to wring concessions from Boeing regarding the merger with McDonnell Douglas? Was Boeing right to make significant concessions to the EU? What might have occurred if the concessions were not made?
Why did the U.S. government decide to reopen the long-running trade dispute between Boeing and Airbus in 2004? Do you think the U.S. position is reasonable? What about the EU’s countercharges? Are they reasonable?
Now that the dispute has gone to the World Trade Organization, what do you think would be a fair and equitable outcome?
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