Welfare effects of variable and fixed cost subsidies in profit, non‐profit and mixed markets

Abstract

Whereas various support mechanisms are in place to correct market failures, knowledge on their welfare effects is still incomplete. This paper, applying a Bertrand approach, studies and compares the effects of variable and fixed cost subsidies on consumer surplus, producer surplus, total surplus and total surplus net of distorting tax effects (‘overall surplus’) in three different market settings: a for‐profit duopoly, a duopoly with two non‐profit organisations and a mixed duopoly, the duopolists in each case supplying mutually exclusive goods or services. In a for‐profit duopoly, more variable cost subsidies lead to an increase of both consumer and producer surpluses, where the latter is impacted most. The higher the level of demand interaction between the two products, the higher the welfare impact. In the non‐profit setting, we establish that the effects of changing fixed cost subsidies on the fiscal cost are more substantial than in the for‐profit duopoly. Subsidies in mixed competition also generate an impact on both producer and consumer surpluses. The effects on overall surplus are shown to depend in complex ways on the level of demand interaction between the products, the shadow cost of taxation and the firms' cost levels.