Optimal price subsidies under uncertainty

Abstract

This paper analyzes the effects of three finite-lived subsidies (fixed price, fixed premium, and minimum price guarantee policies) on investment timing and social welfare. We show how these policies can eliminate the under-investment inefficiency when considering a generic demand function with an exogenous multiplicative shock. We highlight the importance of optimally setting subsidy levels depending on the exogenous shock and demand function parameters. We thus analyze these subsidies and the main findings are threefold. First, the optimal premium subsidy is independent of the exogenous shock. Second, the optimal fixed price subsidy is affected only by uncertainty. Lastly, the optimal minimum price guarantee changes with the drift rate and volatility.