A Subsidization Dilemma: the Effect of Shadow Cost of Public Funds and Consumer Distribution

This article studies subsidy competition in a two-country-two-firm model incorporating bilateral trade, consumer distribution, and a shadow cost of public funds. Governments choose subsidies to maximize domestic or international welfare, with cooperation defined by subsidy choices maximizing international welfare. Under equal consumer bases, the subsidy game is a prisoner's dilemma if and only if the shadow cost is positive. This creates an opportunity for cooperation; without cooperation, however, governments oversubsidize their firms. We find that incentives to cooperate increase with the shadow cost. However, sufficiently unequal consumer distributions can eliminate the prisoner's dilemma, removing the larger country's incentive to cooperate.