Abstract
This paper studies the interaction between production subsidies and innovation subsidies. We develop a model which allows us to calculate the socially optimal subsidies (and how they vary with changes in the economic environment), and to understand how firms react to each type of subsidy. In a three-stage game, the government chooses production and innovation subsidies in the first stage to maximize welfare in the presence of a shadow cost of public funds; two firms invest in cost-reducing RD and the two firms compete in quantities in the last stage. We find that production subsidies crowd out innovation, since they reduce the gain for firms from investing in R&D. On the other hand, providing a production subsidy reduces the cost of the innovation subsidy, and vice versa. The optimal production subsidy is U-shaped with respect to spillovers, while the innovation subsidy is increasing in spillovers. The production subsidy is higher for very low spillovers, while the innovation subsidy is higher for moderate/high spillovers. In equilibrium, because of the innovation subsidy, R&D increases with spillovers, and so does welfare. Optimal subsidies increase with research costs and with the slope of inverse demand, and have an inverted-U shape with respect to initial costs and demand height. We also consider the case of a financially constrained government, as well as the case of a uniform subsidy to production and innovation costs.
Highlights
Governments in both developed and developing countries offer substantial subsidies/tax credits to privately owned firms
On the other hand, providing a production subsidy reduces the cost of the innovation subsidy, and vice versa
The production subsidy is higher for very low spillovers, while the innovation subsidy is higher for moderate/high spillovers
Summary
Governments in both developed and developing countries offer substantial subsidies/tax credits to privately owned firms. Most studies find that the optimal innovation subsidy increases with R&D spillovers Another common finding is that more efficient firms should be subsidized more heavily. Leahy and Neary (1997) develop a model with output and innovation subsidies They find that in the absence of spillovers under Cournot competition (and assuming the government can commit to the optimal output subsidy), R&D should be taxed, as firms over-invest in R&D2. Parish and Mclaren (1982) show, using a theoretical model, that in some cases the input subsidy may be more cost effective to the government than an output subsidy. The model identifies several important criteria which should be taken into account when calculating those subsidies: the level of R&D spillovers (related to intellectual property rights protection), production costs, the price elasticity of demand, and the shadow cost of public funds.
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