MONOPOLY AND SOFT BUDGET CONSTRAINT

A benevolent government may decide to subsidize an unprofitable monopo ly whose profits do not capture all the social surplus from its produc tion. Anticipating this, the firm may underinvest in order to become u nprofitable and extract state subsidies. The resulting welfare loss ma y exceed by many times the deadweight cost of monopoly pricing Committ ing the firm to a price ceiling may soften its budget constraint and t hus reduce welfare. Competition can harden budget constraints in indus tries in which free entry is socially excessive.