Endogenous Choice of Subsidy Instruments in Imperfectly Competitive Markets : A Unit Subsidy versus an Ad Valorem Subsidy

This paper analyzes the endogenous choice problem of subsidy instruments as production expansion (export-promotion) policies. We consider a two-region economy in which firms produce a homogeneous good and sell it in a third region. The government in each region provides a production subsidy to the domestic firm in either a unit or an ad valorem form. Our main result is that selection of a unit subsidy is the dominant strategy for each region and it is welfare superior to an ad valorem subsidy, which offers a justification for the unit subsidy assumption made in the existing literature. We explain the intuition behind this result using the properties of the best responses.