Abstract:
This paper explores policy competition among local governments facing imperfectly competitive
firms with trade cost and vertical linkages as an agglomeration mechanism. We
use a given national tax rate but local governments have a choice to subsidize the mobile
production factor or to provide a public good. Governments have utilitarian motives and
policy has general equilibrium effects. The agglomeration benefits lead large regions to set
relatively high subsidies, which deter smaller regions from setting competitive subsidies.
We show that this effect occurs both when the large region’s government is credible at setting
policy, and when governments set policy simultaneously, allowing for mixed strategy
profiles.
Keywords: spatial general equilibrium, policy competition
JEL-Classification: R38, R50, R53, F12