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.