The role of production subsidies in general equilibrium macroeconomic models with imperfect competition

  • Chang Yee Kwan

    Student thesis: Doctoral ThesisDoctor of Philosophy


    Industrial policy in the form of direct and indirect government subsidy provision to firms in specific sectors of the economy is a common sight in many countries. Some of the most often quoted examples are East Asian economies such as japan and Taiwan. While industrial policy is touted as a possible engine to generate economic growth, empirical validations on the benefits from subsidy provisions have been mixed. It is often argued that a policy of non-intervention by the government may appear to be the optimal policy to pursue.
    However, this contrasts with the historical observations of regular government subsidy provisions to firms in many countries. This thesis constructs a two-sector non-monetary macroeconomic model with monopolistic competition to examine welfare and other related effects of a subsidy provision in the form of lump sum transfers or as some proportion of a variable cost component while firms in the perfectly competitive sector do not.
    This analysis is first carried out in an economy where labour supply is assumed to be exogenous and perfectly inelastic. This serves to provide a simple and clear exposition on the effects of a subsidy provision and to serve as a benchmark analysis to build upon. This is subsequently extended by allowing for labour supply to be endogenously determined to examine labour market effects of subsidy policies. The implications of subsidy provisions in the presence of international trade are studied by constructing a small open economy model where the effects of any policy implementation do not affect world prices or income.
    The principle findings we obtain are that when monopolistically competitive firms receive a cost-reducing subsidy, welfare improvements are always possible regardless of which cost variable the government subsidises. Furthermore, there is always a positive optimal subsidy which raises social welfare. When the supply of labour is endogenous, the corresponding tax imposed on income will always induce an increase in labour supply. Trade is shown not to affect the principle findings: there remains an optimal level of subsidy which is Pareto-improving. A further implication in the open economy context is that the subsidy acts as a form of import-substitution and export-promotion instrument which potentially alters the domestic economy's trade patterns.
    Date of Award2010
    Original languageEnglish
    SupervisorCatia Montagna (Supervisor) & Hassan Molana (Supervisor)


    • General equilibrium
    • Production subsidies
    • Monopolistic competition

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