The Differential Impact of Subsidies on Product Improvements

Abstract

We consider a government that can promote innovation by providing subsidies to different firms. We find that providing a subsidy to only the high-quality firms returns the highest net total surplus and net consumer surplus, even though it resultsin the highest product prices and serves the fewest customers in the market. High-quality product customers are more adversely affected than low-quality ones. In terms of product variety, we show that innovators always withdraw their former products from the market. Finally, the high-quality firm has a higher incentive to hinder the low-quality firm from receiving a subsidy than vice versa.