Government Policy in a Mixed Oligopoly Model with Endogenous Costs

We consider a government regulation of a mixed market (where a private firm competes with a public firm) through R&D subsidization. We propose a mixed duopoly model with endogenous cost structure and tax evasion. It is supposed that only a private firm may evade taxes; a private firm maximizes its profit and a public firm tries to maximize social welfare. It is shown that the optimal R&D subsidy is negatively related to a corporate profit tax rate and positively related to tax evasion costs. Equilibrium allocation even under the optimal R&D subsidy is not efficient because of an increase in social costs of tax evasion caused by R&D subsidization that a government takes into account when it chooses its R&D policy. An increase in tax evasion costs leads to the reduction of difference between effective and equilibrium welfare levels. We also show that privatization of a public firm decreases social welfare.