Subsidy and product diversity in the presence of buyer power

This paper analyzes the effectiveness of government subsidies in promoting product diversity when a downstream firm has buyer power. Using an extension of the Dixit-Stiglitz model of monopolistic competition, we compare the effects of subsidies on the equilibrium number of differentiated products and social welfare in the case where products are sold directly to consumers versus the case where they are distributed through a monopoly retailer with buyer power. We find that a production subsidy promotes product diversity in both cases, but the mechanisms through which a subsidy raises the number of products are different. Compared with the case where products are distributed directly to consumers, retailer buyer power reduces product diversity and social welfare. Furthermore, it weakens the effectiveness of the subsidy in promoting product diversity. At any given subsidy rate the equilibrium number of products is smaller, and a rise in the subsidy rate leads to a smaller increase in the number of products.