City size and the Henry George Theorem under monopolistic competition

We analyze the equilibrium and the optimal resource allocations in a monocentric city under monopolistic competition. Unlike the constant elasticity of substitution (CES) case, where the equilibrium markups are independent of city size, we present a variable elasticity of substitution (VES) case where the equilibrium markups fall with the mass of competing firms and with city size. We then show that, due to excess entry triggered by such pro-competitive effects, the ‘golden rule’ of local public finance, i.e., the Henry George Theorem (HGT), does not hold at the second best. We finally prove, within a more general framework, that the HGT holds at the second best under monopolistic competition if and only if the second-best allocation is first-best efficient, which reduces to the CES case.