Externalities, entry bias and optimal subsidy policy in oligopoly

This article analyses alternative subsidy schemes and long-run entry bias in a new industry that creates positive environmental externalities. It demonstrates that per unit subsidy scheme, despite attracting fewer firms, results in higher industry output and economic surplus in the equilibrium compared to the expenditure equivalent lump-sum subsidy scheme. However, the later leads to higher total surplus, unless spill-over externalities is sufficiently small. Further, free entry equilibrium number of firms may be excessive or insufficient. The first best equilibrium outcome can be implemented through a unique combination of per unit subsidy and lump sum subsidy/tax, which involves positive government expenditure.