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

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 interindustry 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.