The Impact of Subsidies Provided under Different R&D Policies to Vertically Differentiated Firms

Abstract

We consider a simple game-theoretic multistage model in which a government can provide subsidies to different incumbent firms competing in a vertically differentiated oligopoly model. We find that a subsidy provided to the high-quality firm only, returns the highest net total surplus and net consumer surplus. This finding is somewhat unexpected since a subsidy to the high-quality firm results in higher product prices and lower product demands compared to providing the subsidy to the low-quality firm only. Our finding is explained by the fact that (among all cases) a subsidy provision to the high-quality firm only, requires the smallest subsidy, returns the highest product quality, results in the highest degree of product differentiation in the market and the highest firms' profits. Moreover, our study shows that subsidy-receiving firms always withdraw their former products from the market after they introduced a new product into the market. Finally, the high-quality firm has a higher incentive to hinder the low-quality firm from receiving a subsidy compared to the low-quality firm.

Keywords: Heterogeneous Firms, Innovation, New Product Introduction, R&D Policy, Subsidies, Vertical Product Differentiation

JEL Classification: L11, L13, L52, O31, O32, O38