Don’t stop me now: Incremental capacity growth under subsidy termination risk

Abstract

Once a subsidy scheme is close to reaching its goal or loses political support, it may be terminated. An important question for policy makers is how to minimize the negative impact of the risk of subsidy termination on industrial investment. We assume the social planner aims to increase capacity and welfare and uses a subsidy, which has an uncertain lifetime, for the purpose. We examine a monopolist supplying an uncertain demand, faced with the option to expand capacity by irreversibly investing in small increments. We find that the firm installs capacity expansions sooner and, consequently, installs a larger capacity than a firm without a subsidy. A firm’s total investment during the subsidy’s lifetime increases with both the subsidy size and the likelihood of subsidy withdrawal. However, this happens at the cost of less investment directly after the subsidy has been retracted. The optimal subsidy size strongly depends on the point in time at which the social planner aims to maximize the welfare — the further into the future, the larger the welfare optimal subsidy. Furthermore, the welfare optimal subsidy size strongly depends on the social planner’s discretion over adjustments to the subsidy size.