The Signaling Role of Subsidies

This paper investigates the effect of monopoly subsidies on entry deterrence. We consider a potential entrant who observes two signals: the subsidy set by the regulator and the output level produced by the incumbent firm. We show that not only a separating equilibrium can be supported, where information about the incumbent’s costs is conveyed to the entrant, but also a pooling equilibrium, where the actions of regulator and incumbent conceal the monopolist’s type, thus deterring entry. We demonstrate that the regulator strategically designs subsidies to facilitate, or hinder, entry deterrence, depending on which outcome yields the largest social welfare. Furthermore, we compare equilibrium welfare relative to two benchmarks: complete-information environments and standard entry-deterrence games where the regulator is absent.