Asymmetric competition among nation states: A differential game approach

• Tax and public input competition are studied in a differential game.
• Small states are more flexible in their decision-making than larger ones.
• Small size is associated with limited institutional capacity in providing public services.
• We characterize the long run outcome of the game.

This paper analyzes the impact of foreign investments on a small country's economy in the context of international competition. To that end, we model tax and public input competition within a differential game framework between two unequally sized countries. The model accounts for the widely recognized characteristic that small states are more flexible in their political decision-making than larger countries. However, we also acknowledge that small size is associated with limited institutional capacity in the provision of public services. The model shows that the long-term outcome of international competition crucially depends on the degree of capital mobility. In particular, we show that flexibility mitigates against – but does not eliminate – the likelihood of collapse in a small economy. Finally, we note that the beneficial effect of flexibility in a small state increases with its inefficiency in providing public services and with the degree of international openness.