Optimal fixed cost subsidies in Melitz-type models

This paper analyses the reallocation and welfare effects of fixed cost subsidies in a Melitz-type model. In a closed economy, the planner trades off product variety and average productivity effects. Neither subsidies on entry fixed costs nor on operating fixed costs are welfare enhancing. These results reflect the Pareto optimality of the laissez faire equilibrium. In a "small" open economy à la Demidova and Rodríguez-Clare (J Int Econ 78(1):100–112, 2009), an entry fixed cost subsidy does not enhance welfare, while a small operating fixed cost subsidy does. Only the latter affects the relative attractiveness of exporting. The average firm thus reallocates labour from export to domestic activity and operates at a smaller scale, which allows for a larger increase in domestic product variety than in the closed economy.