Externalities, entry bias, and optimal subsidy policy for cleaner environment

• Published date: 01 February 2023
• Author: Rupayan Pal,Marcella Scrimitore,Ruichao Song
• Date: 01 February 2023
• DOI: http://doi.org/10.1111/jpet.12612

Received: 25 October 2021

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Accepted: 4 August 2022

DOI: 10.1111/jpet.12612

ORIGINAL ARTICLE

Externalities, entry bias, and optimal subsidy

policy for cleaner environment

Rupayan Pal

1

|Marcella Scrimitore

2

|Ruichao Song

3

1

Indira Gandhi Institute of Development

Research (IGIDR), Mumbai,

Maharashtra, India

2

Department of Law, Economics and

Social Sciences, Mediterranean

University of Reggio Calabria, Reggio

Calabria, Italy

3

Management College, Ocean University

of China, Qingdao, China

Correspondence

Rupayan Pal, Indira Gandhi Institute of

Development Research (IGIDR), Film

City Road, Santosh Nagar, Goregaon (E),

Mumbai ‐400065, Maharashtra, India.

Email: rupayan@igidr.ac.in and

rupayanpal@gmail.com

Marcella Scrimitore, Mediterranean

University of Reggio Calabria, Reggio

Calabria, Italy.

Email: marcella.scrimitore@unirc.it

Ruichao Song, Management College,

Ocean University of China, Qingdao,

China.

Email: songruichao@qq.com

Abstract

This paper analyses alternative subsidy schemes and

long‐run entry bias in a new industry that creates

positive environmental externalities (both generation

externalities and externalities associated with inter-

industry technology spillovers). It demonstrates that

per‐unit subsidy scheme, despite attracting fewer firms,

results in higher industry output and economic surplus

in the equilibrium compared with the expenditure

equivalent lump‐sum subsidy scheme. However, the

later leads to higher total surplus, unless spillover

externalities are sufficiently small. Further, the free‐

entry equilibrium number of firms may be excessive or

insufficient. A key finding of this paper is that 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 in the presence of positive externalities.

1|INTRODUCTION

Since the late 1960s there has been a tension between whether to rely on regulations or on free

market structure to deal with externalities. It is argued that the simplest way to correct for

negative externalities created by firms would be to allow for the exercise of market power:

output is below the socially optimal and therefore, the amount of the externality would be

below what it would be otherwise (Buchanan, 1969). However, such a measure does not appear

to have desirable effects in the alternative scenario in which firms create positive externalities.

In the latter case it is often argued to be necessary to intervene in the market to encourage more

entry and higher volumes of production, which is in contrast to that in the former case. Several

J Public Econ Theory. 2023;25:90–122.wileyonlinelibrary.com/journal/jpet90

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© 2022 Wiley Periodicals LLC.

countries across the globe have active (direct and indirect) subsidy policies in place to promote

industries with positive environmental benefits, such as the industry of renewable‐energy (e.g.,

solar photovoltaics, wind energy systems, and bioenergies), which also powers electric

vehicles.

1

A rationale to support such industries can be found in the different sources of

positive externalities: the abatement of greenhouse gas emissions achieved through the energy

generation process and the internalization of learning effects, for example, learning how to

produce renewable‐energy, associated with installed capacity (Andor & Voss, 2016;

Reichenbach & Requate, 2012). Given that cleaner energy generation can also generate

environmental externalities through consumption (e.g., a greater usage of electric vehicles

reduces air pollution and induces proenvironmental behavior as well), we refer to the

externalities associated with production and consumption as generation externalities and to the

externalities associated with interindustry learning spillover as spillover externalities.

It is well argued that firms that create positive externalities, either through its production

process or by producing environmentally friendly goods or both, tend to produce at a less than

socially optimal level for any given intensity of product market competition. The reason is that

privately optimal decisions of profit‐maximizing firms do not take into account social benefits

of positive environmental externalities generated by them. Further, firms in these industries

often need to incur high setup costs and face oligopolistic market structure—two characteristics

that lead to a socially inefficient number of firms in the industry in the long run under free

entry in the absence of externalities (Mankiw & Whinston, 1986). Therefore, the existence of

positive externalities, high setup costs, and oligopolistic market structure seem to justify

government interventions in these industries. However, the question arises on the efficiency of

alternative subsidy policies in the long run. Is it better for a budget‐constrained benevolent

social planner to direct subsidies to reduce setup cost compared with incentivizing firms to

produce more in the long run? Can the first‐best equilibrium outcome be achieved in the long

run through subsidization? If yes, what is the socially optimal subsidy scheme? Empirical

evidence of idle capacity creation through subsidized investments further emphasizes the

importance of answering these questions.

2

The objective of this paper is twofold. First, it attempts to compare and contrast welfare

implications of two alternative expenditure equivalent subsidy schemes, lump‐sum subsidy

versus per‐unit subsidy offered directly to firms, when government subsidization is necessary to

promote investments and production of socially desirable goods.

3

Second, it aims to

characterize the socially optimal subsidy scheme in the long run. For these purposes, this

paper develops a model of entry in a new industry considering a fairly general framework, in

which firms are profit‐maximizing agents and upon entry each firm incurs a fixed setup cost,

produces a homogeneous good using nonincreasing returns to scale technology, generates

1

A global review of energy subsidies is provided by Sovacool (2017) who underlines the importance of such policy tool

for social welfare, economic growth, and technological innovation. This review primarly, but not exclusively, deals with

subsidies for fossil fuels and nuclear power. It includes 17 different types of energy subsidies, most of which are direct

to lowering the cost of energy production, in the following main categories: direct financial transfer, preferential tax

treatment, government provision of energy‐related services, and regulation of the energy sector. Taylor (2020) discusses

the evolution of energy subsidies up to the year 2050 and acknowledges that subsidies have led to a worldwide boom of

renewable energies.

2

See, for example, Flora et al. (2014), Wu et al. (2014), and Zang et al (2016).

3

Most of the typologies of energy subsidies included in Sovacool's (2017) analysis are direct to lowering the cost of

energy production. While state grants, preferential loans and guarantees, rebates/exemptions on sales taxes, and tax

credits are awarded per unit of output, liability insurances or loan guarantees can be considered as a lump sum.

PAL ET AL.

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externalities that have net environmental benefit and engages in Cournot competition in the

product market. The social planner is considered to be benevolent and interested in

maximizing the total surplus, which is the sum of economic surplus and net environmental

benefit of externalities, creation by the industry in the long run. Within this framework, we

assume that generation externalities depend on the quantity of the good produced, while

interindustry spillover externalities depend on the number of firms, which follows Reichenbach

and Requate (2012) and Andor and Voss (2016).

We first investigate the relative performance of the two subsidy schemes. We demonstrate

that a lump‐sum subsidy scheme, by lowering setup costs, induces higher firm entry than a

subsidy per unit of output. The latter, conversely, succeeds to enhance the output of firms by

both reducing their marginal production costs and limiting their entry (thus the business‐

stealing effect). The positive effect of introducing limits to quantity reducing entry through a

per‐unit subsidy lets such a scheme result in higher per‐firm and industry output, which causes

it to dominate subsidization of setup costs from the perspective of economic surplus (the sum of

consumers' surplus and producers' surplus minus the subsidy expenditure). However, setup

costs' subsidization through a lump‐sum scheme is shown to dominate output subsidization

when the net benefits of externalities are also considered (i.e., in the perspective of total

surplus), provided that spillover externalities are sufficiently high and let firm entry contribute

to total surplus to a larger extent than output. Our study, moreover, shows that generation and

spillover externalities play a role in defining the optimal subsidy policy, that is, the subsidy

combination that implements the first‐best outcome. We find that the social desirability of

entry crucially depends on the extent of spillover externalities, which may lead firm entry to be

excessive, insufficient, or socially optimal under no subsidization. While a lump‐sum subsidy

scheme corrects for inefficient entry (i.e., a subsidy corrects for insufficient entry and a tax

corrects for excessive entry), a per‐unit subsidy is needed to correct output inefficiencies due to

imperfect competition and generation externalities. Then, the government offers a combination

of per‐unit subsidy and lump‐sum subsidy/tax to achieve the social optimum, thus eliminating

the business‐stealing effect. An exception is when entry is socially optimal (i.e., the negative

effect of entry due to the business‐stealing effect is overcome by the positive effect of entry

through spillover externalities) but a business‐stealing effect is still present, a case in which the

government policy consists in subsidizing firm output only to recover the first‐best allocation. It

emerges that, in the presence of environmental externalities, regulation of firm entry (when it is

needed) should be accompanied by output regulation through an appropriate design of the tax/

subsidy policy.

The rest of the paper is organized as follows. Section 2offers a short survey of relevant

literature, contextualize the present analysis, and highlights its contributions. Section 3

presents the framework of the model. Implications of two alternative expenditure equivalent

subsidy schemes, per unit versus lump sum, on the long‐run equilibrium outcomes are

analyzed in Section 4. Section 5characterizes the optimal policy to implement the first‐best

equilibrium outcome. Section 6concludes. All proofs are relegated to the appendix.

2|RELATED LITERATURE

Two strands of literature are particularly relevant for the present analysis. The first strand of

literature is concerned with free‐entry bias. Starting with Weizsacker (1980), the issue of

inefficiency of free‐entry equilibrium has received considerable attention in the literature.

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