Monopoly and Soft Budget Constraint

Abstract

A benevolent government may decide to subsidize an unprofitable monopoly whose profits do not capture all the social surplus from its production. Anticipating this, the firm may underinvest in order to become unprofitable and extract state subsidies. The resulting welfare loss may exceed by many times the deadweight cost of monopoly pricing. Committing the firm to a price ceiling may soften its budget constraint and thus reduce welfare. Competition can harden budget constraints in industries in which free entry is socially excessive.

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