Coping with inefficiencies in a New Economic Geography model: The unintended consequences of policy interventions

• We provide the social planner version of a standard New Economic Geography model.
• We derive the optimal policy to remedy distortions in the decentralized solution.
• We show that implementing the optimal policy has unintended effects on stability.

This article introduces a social planner version of a central microfounded New Economic Geography model for explicitly answering whether the symmetric equilibrium of the decentralized market economy is socially desirable. We find that savings incentives are too weak, resulting in an inefficiently low capital stock and therefore an inadequate number of product varieties. We derive the appropriate subsidy and taxation scheme to remedy these distortions. Interestingly, implementing the associated policies crucially impacts on the stability of the symmetric equilibrium and has the potential to result in unintended agglomeration processes.