Asymmetric Competition among Nation States. A differential game approach

The aim of this paper is to analyse the impact of foreign investments on a small country's economy in a context of international competition. To that end, we model tax and infrastructure competition within a differential game framework between two unequal sized countries. The model accounts for the widely recognised characteristic that small states are more flexible in the political decision-making than bigger countries. On the other hand, we also acknowledge that small size is associated with limited institutional capacity in the provision of public goods. The model shows that the long run outcome of international competition crucially depends on the degree of capital mobility. We show in particular that flexibility mitigates a small economy's likelihood to collapse without eliminating its possible occurrence. Finally we highlight that the benefcial effect of flexibility of a small state increases with its inefficiency to provide public infrastructures and with the degree of international openness.