Discussion Papers In Economics
And BusinessFree entry, regulatory competition, and globalization
Kaz Miyagiwa and Yasuhiro Sato

Discussion Paper 12-02

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANFree entry, regulatory competition, and globalization
Kaz Miyagiwa and Yasuhiro Sato

Discussion Paper 12-02

March 2012

Graduate School of Economics andOsaka School of International Public Policy (OSIPP)
Osaka University, Toyonaka, Osaka 560-0043, JAPANFree entry, regulatory competition, and globalization∗
Kaz Miyagiwa†

Yasuhiro Sato‡

March 5, 2012

Abstract
This paper examines the optimal entry policy towards oligopoly in a globalized world.
In an open economy free entry is socially suboptimal, but corrective tax policy to curb
entry proves insufficient unless internationally harmonized. Thus, while conferring the gains
from trade, globalization prevents countries from pursuing the optimal entry policy. Whencountries are small, the gains from trade dominate the losses from a suboptimal entry policy,
but as markets grow the result is reversed, making trade inferior to autarky. Therefore, theneed for tax harmonization grows as the world economy grows. This paper also contributes tothe international tax competition literature through the discovery of the reverse home market
effect.

JEL classification: F15, H77, L13
Keywords: Entry Policy, Excessive entry, Globalization, Regulatory competition∗

We thank participants at NARSC, ARSC and the JSPS Kakenhi Kiban (A) seminar held at Kwansei Gakuin
University for helpful discussions and comments. Special thanks go to Jacques-F. Thisse for stimulating conversations that set this project in motion. We acknowledge the financial support by RIETI, the JSPS Grants-in-Aid for
Scientific Research (S, A, B, and C) and the MEXT Grant-in-Aid for Young Scientists (B).
†
Florida International University and Emory and Osaka Unviersities, e-mail: kmiyagiwa@gmail.com‡
Osaka University, e-mail: ysato@econ.osaka-u.ac.jp

1

Introduction

The idea that free entry leads to a social optimum has long been cherished as an irrefragable truthin economics. However, this shibboleth has recently been challenged by a number of researchers.1
In particular, Mankiw and Whinston (1986) have demonstrated that free entry results in too muchcompetition in oligopoly if entry reduces output per firm at the margin. This condition, dubbed
the “business stealing effect,” is so mild that it holds in a wide variety of situations; in particular,in Cournot competition. While the Mankiw-Whinston analysis pertains to a closed economy, withthe world getting fast globalized, it is natural to wonder whether their results carry over intact toa globalized environment.
In a global economy the question whether unrestricted entry results in too much competition –and, if so, what constitutes an optimal intervention policy – can be approached from the perspectiveof an individual country or the entire world. The added dimensionality points to a possible conflictand policy coordination dilemma among individual countries. It is possible, for example, that entry
is excessive for the whole world but too little from an individual country’s perspective. Even if
all countries agree that entry is excessive, it is another matter whether they can correct the entry
problem.
A global economy confronts individual countries with yet another policy dilemma, which concerns the choice between free trade and autarky. On the one hand, the result of Mankiw and
Whinston (1986) shows that a country in autarky can attain a social optimum by restricting entry.
On the other hand, by the result of Brander and Krugman (1985) an open economy enjoys thegains from trade under oligopoly with free entry. But, if free trade prevents it from instituting thesocially optimal entry policy, a country faces this fundamental trade-off: retreating to autarky, acountry can pursue the optimal entry policy but forgoes the gains from trade, whereas it faces the
opposite dilemma when it remains open to trade.
The objective of the present paper is to address these policy issues brought about by globalization. To that end, we consider a two-country partial equilibrium model of Cournot competition
with free entry. While Mankiw and Whinston (1986) consider regulating the number of active
1

Also see von Weizsacker (1980), Perry (1984), and Suzumura and Kiyono (1987).

1

firms directly with a governmental edict, here we explore the corrective role of corporate income
tax as an indirect measure to control entry. The two approaches are fully equivalent, provided thatthe tax revenues are rebated back to society in lump-sum fashion. However, our approach has theadded advantage of relating to the growing literature on international tax competition.
Our main findings can be summarized as follows. We find first that in a globalized economy
free entry also results in excessive competition. Thus, each country has the unilateral incentive
to tax domestic firms to curb entry. However, taxation of domestic firm promotes entry in theforeign country. As entry by foreign firms undermines the efficacy of domestic tax policy, eachcountry chooses too low a tax rate relative to when there are no such spillovers. Hence, in a global
economy entry remains excessive even with government interventions. Our analysis implies thatinternational tax policy harmonization is indispensable for the achievement of a social optimum
in a globalized economy.
As for the dilemma concerning the choice between free trade and autarky, the answer depends
on market size. When markets are small, the gains from trade dominate the losses from excessive
entry, so globalization benefits countries. However, when both markets grow sufficiently large, theabove result is reversed, and autarky becomes welfare-dominant. Thus, the need for coordinatedtax policy grows as the world economy grows.
These results are obtained analytically under the simplifying assumptions that include symmetry, linearity and arbitrarily low transports. Relaxing these conditions makes the model analytically intractable, but numerical analysis yields the same results, demonstrating that the basic
mechanism yielding our analytical results is at work in more general settings. In addition, when
we relax the symmetry assumption, the numerical analysis gives us two new results. First, themodel exhibits the reverse home market effect, that is, the large country hosts a smaller number ofnational firms relative to its market size compared with the smaller country. This contrasts sharply
with the standard result in economic geography and trade (see e.g., Krugman 1980; Fujita et al.
1999). Second, the larger country chooses a lower tax relative to the smaller country. Further, thistax difference across countries widens as the counties becomes more asymmetric in size. These
results also contrast sharply with the well-known result in the standard tax competition literature.

2

By the last two results this paper also contributes to the strand of the tax competition literaturethat goes back to Wilson (1986) and Zodrow and Mieszkowski (1986). These authors have shownthat unilateral taxation of internationally mobile factors increases the tax base in the other country
through factor flights. In the present study, factors are internationally immobile but similar results
emerge as corporate taxation affects the distribution of national firms across countries. This paper
is however more closely related to the new strand of literature investigating international capitaltax competition under imperfect competition. For example, Ludema and Wooton (2000) andHaufler and Wooton (2010) have examined how the market (population) size affects the tax rates
and welfare under Cournot competition. While the numbers of firms are fixed in those studies,
here they are determined endogenously through entry. Thus, our model complements those studies
by examining the effect of globalization on welfare as globalization affects firms’ distributions.
The organization of this paper is as follows. In Section 2, we explain the general model. Section
3 examines the case of symmetric demands and negligible trade costs. Section 4 considers the caseof symmetric linear demands and also the effects of trade costs. Section 5 examines the case ofasymmetric markets. Section 6 concludes.

2

The general modelThis is a two-country partial equilibrium model. Call two countries (regions) East and West. Eachcountry has a large number of potential firms capable of producing the goods in question, of which
mi firms actually enter in country i (i = e, w). Firms are immobile across national borders, so
there is no confusion in referring to a representative firm domiciled in country i as firm i. The
goods are considered homogeneous. Let pi (Qi ) denote the (inverse) demand in country i, where
Qi is total quantity sold in country i. Assume continuous differentiability with first derivatives
denoted by p0i < 0. (Primes denote derivatives.)
On the production side, firms face constant marginal cost c and incur setup cost ki on entry.
Firms also pay transport cost t for each unit they export. Transport cost is low enough for firms
to always export positive quantities, the condition to be made more precise below. If qij denotes3the quantity sold by firm i in country j (i, j = e, w), industry supply in market i equals

Qi = mi qii + mj qji .

(1)

Firms i pay the corporate income tax τi to their home country i, earning the net profit2

πi = (1 − τi ) [(pi (Qi ) − c)qii + (pj (Qj ) − c − t)qij ] − ki .

(2)

The entry cost ki is assumed to increase as more firms operate in country i, so

ki = k(mi )with ki0 > 0.3 This assumption implies that entry entails negative externalities or congestion. Suchis the case, for example, if land supply is limited so firm concentration drives up the land rent, an
important component of setup cost.
Firms consider the two national markets segmented, and choose home and foreign sales, qii
and qij , separately to maximize total profits (2), given all other firms’ outputs. The first-orderconditions for firm i arepi (Qi ) + p0i (Qi )qii − c = 0(3)pj (Qj ) + p0j (Qj )qij − c − t = 0.

The second-order conditions are assumed to hold; i. e.,

2p0i (Qi ) + p00i (Qi )qii < 02(for all i and j).

We consider tax on operating profits of firms. The result is much the same even if we tax the profit net of entry
cost.
3This assumption allows us to determine the distribution of firms between countries at t = 0. Alternatively, we
can make entry cost constant, solve the model with t > 0 and take a limit of t → 0 to obtain the same results.
If instead entry entails positive externalities (i.e., ki0 < 0), free entry induces infinitely many firms to enter. Our
assumption excludes this possibility.

4The first-order conditions can be arranged to yield the equilibrium outputs:pi (Qi ) − c≡ qii (Qi )p0i (Qi )pj (Qj ) − c − tqij∗ = −≡ qij (Qj ).
p0j (Qj )qii∗ = −(4)

On substitution, the equilibrium profit can be expressed as"#(pi (Qi ) − c)2 (pj (Qj ) − c − t)2πi (Qi , Qj , τi ) = (1 − τi ) −−− ki .
p0i (Qi )p0j (Qj )(5)

If mi is treated as a continuous variable as is standard in the literature, free entry implies zero net
profit for all active firms, and hence:

πi (Qi , Qj , mi , mj , τi ) = 0,i, j = e, w.

(6)(for all i and j).

(7)

Further, substituting from (4) into (1) yields

Qi = mi qii (Qi ) + mj qji (Qi )Equations (6) and (7) form a four-equation system which can be solved for equilibrium industry
supplies, Qe , Qw , and the equilibrium numbers of active firms, me and mw . The equilibrium firm
outputs qii and qij follow from (4).
Governments impose tax τi and returns the tax revenues in lump-sum fashion to domestic consumers. Thus, country i’s national welfare Wi comprises the consumer surplus, the total domestic
industry profit and the tax revenue and expressed as:ˆ Qi
pi (x)dx − pi (Qi )Qi + (pi (Qi ) − c)Qii + (pj (Qj ) − c − t)Qij − mi ki .

Wi =

(8)

0

where the first two terms represent consumer surplus, the next two measure the sum of firm profits
and tax revenues, while the final term is the total setup cost. The tax revenues and rebates do
not figure explicitly because they cancel each other in aggregation, implying the absence of fiscal
5externality, i.e., there is no externality due to changes in the tax base. However, tax policy entails
an entirely new type of externality through changes in distribution of firms across countries andaffects the degree of excess in entry in the world.

3

Entry and corporate income tax in a global economy

If there is no trade, free entry results in too much competition but it is easy to check that excessive
entry can be corrected, and a social optimum achieved, with corporate income tax, as implied by
the Mankiw-Whinston analysis. Our objective is to revisit this policy prescription in a global
economy. Thus, we begin our analysis with the question: is competition excessive in an open
economy as in a closed economy? An extension to a global economy, however, raises two essential
questions that do not surface in the analysis of a closed economy. First, if there is too muchcompetition, does each country have the unilateral incentive to tax its firms? Second, if eachcountry has such an incentive, can two countries attain a social optimum without harmonizing
their tax policies ?
In this section we address these questions under the assumptions that market demands are
symmetric and transport cost t are arbitrarily small (which we relax later). Use (1) and (4) towrite industry supply in each market as

Qi = −mi (p(Qi ) − c) + mj (p(Qi ) − c − t).
p0 (Qi )As t approaches zero, this expression simplifies to

Qi = −

M (p(Qi ) − c)p0 (Qi )6(9)where M = me + mw denotes the total number of active firms in the world. Differentiation yields:p(Qi ) − c
∂Qi
=−
>0
∂mi
(1 + M )p0 (Qi ) + Qi p00 (Qi )∂Qjp(Qj ) − c
=−
>0
∂mi
(1 + M )p0 (Qj ) + Qj p00 (Qj )


∂qii
∂qji
p00 (Qi )(p(Qi ) − c) ∂Qi== −1 +<0∂mi∂mi(p0 (Qi ))2
∂mi


∂qjj
p00 (Qj )(p(Qj ) − c) ∂Qj∂qij== −1 +< 0.
∂mi∂mi(p0 (Qj ))2
∂mi

(10)

The last two inequalities confirm the presence of the Mankiw-Whinston (1986) business-stealing
effect in a global economy, namely, entry reduces the existing firm’s outputs at home and abroadat the margin.
The free-entry conditions are now given by(p(Qi ) − c)qii + (p(Qj ) − c)qij =k(mi ).
1 − τi(11)

Differentiating (11) and using the derivative results in (10) leads to our first result:
Proposition 1 Suppose demands are symmetric and transport costs are negligible. When a country raises its tax, domestic firms exit by a greater number than foreign firms enter, causing thetotal number of active firms in the world to decline.

Proof: See Appendix A
The presence of the business-stealing effect implies excessive entry for a social planner. The
marginal entrant increases total supply which is good for society but causes other firms to contract
output which is bad for society. However, the marginal entrant does not take the second effect into
consideration when making the entry decision. Thus, free entry leads to too much competition.
Given that entry is excessive in a global economy, we turn to our next question: does eachcountry have the unilateral incentive to control entry by its domestic firms? We answer thisquestion by evaluating ∂Wi /∂τi at τi = τj = 0. Our finding is given in7

Proposition 2 Suppose that demands are symmetric and transport costs are negligible. When
there are no initial taxes, each country has the unilateral incentive to introduce corporate income
tax.

Proof: See Appendix B
Proposition 2 holds because by proposition 1 taxation in one country reduces the total numberof firms in the world, and improves national welfare, given excess entry. Hence, each country has
the unilateral incentive to intervene. Given such incentives for intervention, the next question
we ask is: can countries attain a social optimum when acting unilaterally? In other words, whatis the total effect of the two taxes levied unilaterally? To answer this question, we consider thethree-stage game, in which each country first chooses the tax rate unilaterally to maximize its
welfare, given the other county’s tax rate, then firms decide whether to enter and finally entrant
firms engage in Cournot competition in the manner described above. We look for the symmetricsubgame-perfect Nash equilibrium of this game.
To understand the welfare properties of the equilibrium of this game, consider the effect of an
exogenous change in the tax rate in country i on world welfare, namely:∂Wi ∂Wj∂(Wi + Wj )
=
+
.
∂τi
∂τi
∂τi
As each country chooses the tax rate to maximize its welfare, we set ∂Wi /∂τi = 0 in the above
expression and observe that the following holds at a symmetric equilibrium:∂(Wi + Wj )|symmetric equilibrium =∂Wj.
∂τi symmetric equilibrium

Thus, the sign of ∂Wj /∂τi |symmetric equilibrium evaluated at the equilibrium tax rate indicates whether
the equilibrium tax rate is too high or too low relative to a global optimum. Appendix C showsthat this derivative is positive, implying that the equilibrium tax rate is too low, i.e., there is still
too much entry after taxation. This important result is noted in8Proposition 3 In a global economy, when both countries impose the optimal corporate taxes without harmonization, entry remains excessive.
Proof: See Appendix C.
This proposition says that uncoordinated taxation fails to completely remove excessive entry.
To understand the intuition recall that unilateral taxation decreases the number of domestic firms
by proposition 1, reducing competition and benefiting the taxing country. However, also by proposition 1, tax in one country promotes entry in the foreign country, thereby partially offsetting thebeneficial effect of taxation. Unable to fully appropriate the benefits of its tax policy, a country
chooses too low a tax rate relative to what it would choose in the absence of such policy spillovers.
It is straightforward to show that internationally harmonized tax policy can attain the global
social optimum. Since the world itself is a close economy and two countries are symmetric, eachcountry’s welfare can be expressed as the function of the total number of firms M in the world.
Then, as in Mankiw-Whinston (1986) there exists the optimal number of firms in the world. Thisand the first-order conditions determine the corresponding firm output and hence the firm’s net
profit. The zero profit condition then uniquely determines the required tax needed for a social
optimum.
In summary, free entry results in too much competition in a global economy as it does in aclosed economy, so that each country has the incentive to tax its domestic firms to combat the
problem of worldwide excessive entry. However, due to policy spillovers the optimal taxation foreach country, when chosen unilaterally, proves insufficient, leaving entry still excessive the world
over. Thus our analysis implies international harmonization of tax policy is indispensable for asocial optimal from the word’s perspective.

4

Symmetric linear demand and transport cost

In this section we assume linear demands and entry cost to get sharper results. We consider thedemands of the form:
pi = A −9Qi,nwhere A is demand intercept and n is the number of consumers in each country (the assumptionof symmetric demand is retained) and use the entry cost function

ki =

kmi
.
2

where k > 0 is constant. This entry cost function is consistent with the simple land market modelwith fixed land supply.4 Choose the unit so that A − c = 1. Then, country-i welfare can be
expressed as(1 − pi )2+ si + mi πi .
Wi = n2(12)where s is the tax revenue per firm.
Cournot competition yields the following equilibrium outputs and prices

qww = npw ,qwe = n(pe − t)qee = npe ,qew = n(pw − t)

pw =1 + tme
,
1+M

pe =

(13)

1 + tmw.
1+M

In the current setting, trade occurs if and only if pi > t. This condition is written 1/(1 + mi ) > t.
Also, Cournot competition makes sense only if mi ≥ 1.5 These two requirements combine to yield
the following regularity condition, assumed to hold throughout the analysis:
1
1
≥
> t.
2
1 + mi4This entry cost has another interpretation: Suppose there are M potential firms and they are heterogeneouswith respect to entry cost. M is assumed to be exogenous and sufficiently large. If the entry cost is represented by
κ/h where h follows a Pareto distribution with a shape parameter equal to one and with support [κ, +∞), there isa threshold level h∗ such that firms with higher h than h∗ enter the market and firms with lower h than h∗ do notenter. The entry cost for a firm h∗ becomes a linear function of mi (more precisely, kmi /2, where k is now definedas k = 2κ/M ). Pareto distributions are often assumed in models of firm heterogeneity; see Helpman et al. (2004),
for instance.
5
We assume that there is no integer problem.

10Substituting (13) into the firm’s profit (2), we obtain these free entry conditions:kmw
2(1 − τw )
kme
φe =
,
2(1 − τe )

(14)

φw =

where φi is defined byφi ≡ n

1 + tmj
1+M2

1 − t(1 + mj )
+n
1+M

2
,

i 6= j.

Two equations in (14) determine the number of firms me and mw for given tax rates τe and τw .
Using these relations, we obtain the next proposition, which generalizes proposition 2 to the caseof non-negligible trade costs.
Proposition 4 In the case of symmetric linear demands, with no initial taxes, each country has
the unilateral incentive to introduce corporate income tax at any non-prohibitive transport cost t.

Proof: See Appendix D.
As shown by Brander and Krugman (1983), there are gains from trade under Cournot competition with free entry. However, since countries cannot completely eliminate excess entry without tax
policy harmonization, the equilibrium outcome is suboptimal for an open economy. In contrast,
in autarky a country can attain a social optimum with respect to entry but forgoes the gains fromtrade. Because of this trade-off, it is not obvious whether free trade welfare-dominates autarky.
We investigate this issue using the linear model of this section. Our finding is summarized in
the next proposition.6
Proposition 5 Suppose demands are linear and identical across countries. Assume that transport
costs are negligible.
(A) When countries are small, the gains from trade dominate the losses from excess entry inmagnitude, and hence trade welfare-dominates autarky.
6

Appendix E shows the existence and uniqueness of symmetric Nash equilibrium of the tax game, and Appendix
F describes the case of autarky.

11(B) When countries are sufficiently large, the result in (A) is reversed so autarky welfaredominates trade.

Proof: See Appendix G.
We only outline the proof of the proposition here (the complete proof is in appendix G). Let
the superscripts a and o denote the equilibrium value in autarky and open economy, respectively.
Key to the proof are the following two welfare expressions. The first one

Wia =N ma (2 + ma ) k(ma )2−4(1 + ma )22{z} | {za }
|
≡Sia

≡Ci

gives the optimal symmetric welfare under autarky, where each government can attain a social
optimum while forgoing the gains from trade. The secondWio =N mo (1 + mo ) k(mo )2.
−(1 + 2mo )2
2 }
{z
|
|
{z
}
o
≡Sio

≡Ci

measures the equilibrium symmetric welfare under free trade, in which each country captures
the gains from trade but fails to eliminate excess entry. In these expressions, Sil represents thegross social surplus, i.e., the sum of consumer surplus and profits inclusive of entry costs, and Cil
represents the total cost of entry.
Let N denote the total number of consumers in the world. By symmetry N = 2n. A calculationshows that ma = 1 and mo ≈ 1.1571 at N = 16k; see (E2) and (F4) in the appendix. Since there
must be at least one active firm in each country, our model makes sense only if N ≥ 16k, which
we assume throughout the remainder of the analysis. Then, computation yields Wio /Wia ≈ 1.186
at N = 16k, that is, when N takes on its minimum value, each country’s welfare is greater withtrade than in autarky. However, this welfare ranking is reversed when N is sufficiently large. To

12show that, consider the ratios
4(1 + 1/ma )2 (1 + 1/mo )
Sio
=
Sia
(1 + 2/ma )(2 + 1/mo )2
2

Cio
mo
.
=
Cia
ma
(E2) and (F4) in the appendix imply that limN →+∞ ma = +∞ and limN →+∞ mo = +∞ but
limN →+∞ mo /ma = +∞. Therefore, as N goes to infinity the surplus ratio Sio /Sia converges toone, but the entry cost ratio Cio /Cia grows without bounds. These two limit results imply that
Wio /Wia < 1 for a sufficiently large N , that is, each country is better off in autarky than in an
open economy when the markets are sufficiently large. In the next section we demonstrate theseresults by numerical analysis.
Proposition 5 implies that, as the world economy grows, countries are more likely to be worse off
in a globalized economy than in autarky. The intuition can be explained as follows. In the presenceof entry cost firms face decreasing average cost so they are more efficient in a larger market. As aresult, there are a fewer firms in a large country than a small country relative to the market size. In
the case of linear demands, if the market grows by ten percent, the number of firms grows roughly
by five percent. Trade doubles the market size, allowing firms to decrease average cost, and hence
proves more valuable when the country is small. In contrast, if the country is large, it can realize
substantial scale economies without relying so much on trade, so trade is relatively unimportant.
Therefore, when the world economy is small, the gains from trade dominate the welfare loss fromthe suboptimal entry policy, whereas when the world is sufficiently large, the countries are betteroff giving up the gains from trade and instead pursuing the optimal entry policy in autarky.7
Proposition 5 therefore implies that the need for international tax harmonization increases as theworld economy grows.
We now examine how robust our results are in the presence of non-negligible trade cost. The
model is too cumbersome analytically, so we resort to numerical analysis. Our simulation results
are presented in the four panels of figure 1, where we set the entry cost parameter equal to k = 1
7This result is unaltered qualitatively if we focus on per capita welfare (i.e., Wi /n) because we can readily seethat sgn[Wio /n − Wia /n] = sgn[Wio − Wia ]. See also Figure 1-(d).

13(so that entry cost equals ki = mi /2) and each country’s consumer population equal to n = 20.8
The numerical results are consonant with our analytical results, demonstrating the robustness of
our results in the presence of non-negligible transport cost.

[Figure 1 around here]

Begin with the analysis of the relationship between excessive entry and trade cost. To that end,
represent the measure of excess in entry by the ratio (M o /M ∗ ), where M o denotes the number of
the total firms in an open economy with uncoordinated tax policy and M ∗ the optimal number offirms that maximizes world welfare We + Ww . Panel 1-(a) shows that entry remains excessive evenat non-negligible transport cost, thereby demonstrating the results of proposition 3 in the presenceof transport cost. The panel also shows that the degree of excess in entry falls as transport costrises. The intuition underlying this result is that, the higher the trade cost, the less open the
countries, and hence unilateral tax does not induce as much entry in the foreign country. The
weaker spillover effect makes domestic tax policy more effective in combating excessive entry, andthe degree of excess in entry declines.
The next three panels concern the impact of trade on welfare under optimal tax policy, i. e.,
the difference in welfare between trade and autraky. Panel 1-(b) illustrates the effect of changes inmarket size (population) on the impact of trade on welfare at four different transport costs (t = 0,0.001, 0.025, 0.05). The trade costs are differentiated by the thickness of the curves; the thicker the
curve, the higher the transport cost. Each curve first rises from one but eventually falls below zero,
indicating that at small populations trade welfare-dominates autarky while at larger populations
the converse is true. Thus, panel 1-(b) shows that proposition 5 holds at non-negligible transport
costs in our numerical analysis. The underlying intuition is already discussed following proposition
5.
Panel 1-(b) also shows that a rise in transport cost reduces the benefits of trade at any given
population. The intuition is the same as above; at higher trade cost, the spillover effect is weaker,
and the tax policy more efficacious, thereby making autarky more attractive relative to trade.
8

The cases where k = 0.5 and1.5 yield similar results.

14This result is more evident in panel 1-(c), where transport cost continuously changes while thepopulation is fixed at three levels (n = 10, 15, 20, i.e., N = 20, 30, 40). Finally, in panel 1-(d) we
evaluate the welfare effect of population changes in per capita terms. As with the corresponding
aggregate measures in panel 1-(b), trade welfare-dominates autarky at small populations but theconverse holds at larger populations. The only difference is that here, unlike in panel 1-(b), thebenefits of trade per capita monotonically decline as the world population grows.

5

Asymmetric countries

In this section we relax the symmetry assumption in market size. Assume without loss of generalitythat West has the fraction θ of the world population, where 1 > θ ≥ 1/2, i.e., West is the largerof the two countries. For simulation purposes the total (world) population is set at N = 30, theentry cost parameter at k = 1, and the transport cost at t = 0.025.9[Figure 2 around here]

The first question we address concerns the relationship between the population distribution
and the firm distribution across countries. We begin by evaluating the ratio (mw /me )/ [θ/(1 − θ)]in the absence of taxes. The numerator of this expression measures the number of domestic firms
located in West relative to East, while the denominator measures the relative population residing
in West. If this ratio equals one, there is a perfect proportionality between the two distributions
across countries; that is, each country has the same numbers of domestic firms per capita. Figure
2 shows, however, this ratio to be less than one at all relevant values of θ, meaning that a large
country has a fewer domestic firms per capital compared with a small country. This result contrasts
sharply with the home market effect, the well-known result in the standard literature stating thata large country has a proportionately greater number of domestic firms. Since our result reverses
this statement, we call ours the reverse home market effect.
9

We checked the robustness of the results against different parameter values: N = 20, 40, k = 0.5, 1.5 andt = 0.001, 0.05. Under these alternative parameter values, the results are unaltered qualitatively.

15

The reverse home market effect has a simple intuitive explanation. We already noted earlier
that in the presence of entry cost a larger market is served by a relatively fewer and more efficientfirms than a smaller market due to the decreasing average cost. The same intuition holds in a
global economy. The reverse home market effect is also featured in the work of Sato and Thisse(2007). There, however, it arises for the entirely different reason; competition among firms in thelocal labor market, and hence is distinct from ours. 10[Figure 3 around here]

We next turn to the relationship between the market size asymmetry and the optimal tax
rates. Figure 3 depicts how the equilibrium tax rates change as θ increases from 0.5 to 0.8 (thelarge country gets larger). The large country’s tax rate is represented by the solid line, and thesmall country’s tax rate by the dashed line. Figure 3 reveals two important results. First, thethick line lies below the dashed line in the figure, indicating that the tax rates are lower in thelarge country at all θ > 1/2. Second, as the population shifts more to the larger country, the tax
falls monotonically in the large country while rising monotonically in the small country. Thus, as
countries become more asymmetric, the tax rates diverge further.
These results can be explained intuitively as follows. Due to the reverse home market effect, thelarge country has a fewer firms relative its population compared with the small country, implyingthat entry is less excessive in the large country. Therefore, there is less need for corrective tax inthe larger country and hence the tax is lower there.
These results contrast sharply with the well-known result in the standard tax competition
literature, which predicts that the tax rates are higher in the large country than in the small
country.11 However, it is interesting to note that this standard result is not always borne out
10
Head et al. (2002) analyze three models involving increasing returns and trade in order to assess the robustnessof the home market effect against alternative modeling assumptions. They find that, when the traded goods aredifferentiated between trading countries and not among firms, even a fairly standard trade model can exhibit thereverse home market effect.
11
For earlier contributions, see Bucovetsky (1991) and Wilson (1991) on perfectly competitive product markets.
More recent studies, using models of imperfect competition, find that in the presence of the home market effectthe large country set a higher tax rate than the small country to capture the “agglomeration rent.” See Andersson
and Forslid (2003), Baldwin et al. (2003), Baldwin and Krugman (2004), Borck and Pflüger (2006), Haufler andWooton (2010), Kind et al. (20009, Ludema and Wooton (2000) and Ottaviano and van Ypersele (2005). Haufler
and Pflüer (2004) examine the commodity tax competition under monopolistic competition.

16

empirically. For example, Devereux et al. (2002) have found mixed results in their study of theeffective corporate tax rates among OECD countries. According to this study, for instance, larger
countries such as Germany, Japan, and the United States choose higher effective corporate taxes
than their smaller counterparts, Austria, Finland and Sweden, in consonance with the standard
literature, whereas smaller countries such as Belgium and Greece also set higher taxes than theirlarger counterparts, France and the United Kingdom, contradicting the standard result in theliterature; see figure 7 in Devereux et al. (2002). Our analysis may offer a possible explanation
why empirical findings are inconclusive.

[Figure 4 around here]

Finally, we examine the effect of country asymmetry on the impact of trade on welfare, both inaggregate and per capita terms. In figure 4, the benefits of trade are represented by the solid line
for the large country and by the dashed line for the small country. As the large country gets larger,
the benefits of trade decrease for the large country, but increase for the small country in both terms.
The intuition is now familiar. Since the larger country can realize the substantial economies ofscale without the market-expanding effect of trade, tending to the entry problem takes precedence
over accessing a small foreign market. As the distribution becomes more lopsided, the benefits oftrade further decline in the large country, while the converse holds in the small country.

6

Concluding remarks

In a close economy free entry leads to too much competition in oligopolistic industry, but a social
optimum is attainable with corrective tax policy. This paper reconsiders this Mankiw-Whinston(1986) result in an open economy. We first show that without government interventions the problem
of excessive entry inheres in a globalized world. More importantly, in a global economy corrective
tax measures cannot completely eliminate excessive entry without international tax harmonization,
because taxation in one country promotes entry in the foreign country, partially offsetting the effect17

of the tax and reducing the efficacy of the tax policy. For this reason, countries set taxes too low
relative to a global optimum, leading to a suboptimal outcome.
However, globalization also generates the gains from trade as shown by Brander and Krugman(1983). Thus, the overall welfare effect of globalization hinges on the balance between the gains
from trade and the welfare loss from the inability to pursue the optimal entry policy in an open
economy. When countries are small, the gains from trade dominate so trade raises aggregate
welfare. When countries are large, however, the result reverses itself, implying that autarky is
better than trade. Thus, our analysis indicates that coordinated tax policy is essential for a global
optimum and that the need for tax harmonization is increased as the world economy grows.
These results are obtained under the symmetry assumption. Although we also consider the caseof unequal populations, in the real world countries are heterogeneous in other dimensions, such astechnologies and capital endowments, as well. Our analysis should be extended to such asymmetricenvironments. Our model can also be extended to more than two countries. Such an extension
allows us to study the welfare implications of partial coordination i.e., coordination by a subset
of countries. Another question one can ask is whether the multiplicity of countries diminishes orincreases the degree of excessive entry the world over. A third possible extension of our analysis
is to other types of imperfect competition such as Bertrand and monopolistic competition. While
Bertrand models are likely to behave similarly, monopolistic competition models can behave quite
differently. Finally, it is worth investigating the effects of sequential entry as well as sequential
tax decisions, as globalization may have different impacts on the leader and the follower. These
extensions require separate treatment and are left for future research.

Appendix A: Proof of Proposition 1.
The free entry condition (11) forms a two-equation system that is solvable for Qe and Qw in
terms of me and mw for given τe and τw . Denote the derivative of the left-hand side of (11) withrespect to mj by βij and define B by

 β11 β12 B≡,
β21 β2218

where
∂qii
∂Qj
∂qij
k 0 (mi )∂Qi0+ (p(Qi ) − c)+ qij p (Qj )+ (p(Qj ) − c)−β11 ≡ qii p (Qi )
∂mi
∂mi
∂mi
∂mi
1 − τi
∂q
∂Q
∂q
∂Q
ii
j
ij
i
+ (p(Qi ) − c)+ qij p0 (Qj )+ (p(Qj ) − c)β12 ≡ qii p0 (Qi )
∂mj
∂mj
∂mj
∂mj
∂Qi
∂qji
∂Qj
∂qjj
β21 ≡ qji p0 (Qi )+ (p(Qi ) − c)
+ qjj p0 (Qj )+ (p(Qj ) − c)
∂mi
∂mi
∂mi
∂mi
∂Qi
∂qji
∂Qj
∂qjj
k 0 (mj )β22 ≡ qji p0 (Qi )+ (p(Qi ) − c)
+ qjj p0 (Qj )+ (p(Qj ) − c)
−
.
∂mj
∂mj
∂mj
∂mj
1 − τj0

Differentiating the system (11), we obtain








0


2

1  β22 −β12   k (mi )/(1 − τi )  ∂mi /∂τi 

=



det(B)
0∂mj /∂τi−β21 β110k (mi )
 β22 =.
det(B)(1 − τi )2−β21
The determinant of B is positive since
k 0 (mi )(1 − τj ) + k 0 (mj )(1 − τi )∂Qj
∂Qi
det(B) = −+ qjj p0 (Qj )qii p0 (Qi )n(1 − τi )(1 − τj )
∂mi
∂mj

0
0
∂qii
∂qjj
k (mi )k (mj )+n(p(Qi ) − c)+ n(p(Qj ) − c)
>0
+
∂mi
∂mj
(1 − τi )(1 − τj )where the inequality comes from the assumptions on p(Qi ) and k(mi ), and (10). We also knowthat β21 < 0 and β22 < 0. Hence,
∂mi
<0
∂τi

and

∂mj
> 0.
∂τi

Moreover, (10) implies that ∂Qi /∂mi = ∂Qi /∂mj , ∂Qj /∂mi = ∂Qj /∂mj , ∂qii /∂mi = ∂qii /∂mj ,∂qjj /∂mi = ∂qjj /∂mj , ∂qij /∂mi = ∂qij /∂mj and ∂qji /∂mi = ∂qji /∂mj , which lead to β22 < β21 <190 and hence −∂mi /∂τi > ∂mj /∂τi > 0. Using these results, we have
∂mi
∂mj
>
.
∂τi
∂τi

Appendix B: Proof of Proposition 2.
Differentiate (8) and evaluate it at τi = τj = 0 to obtain


∂Qi
∂qii
∂Qj
∂Qi
0
+ mi qii p0 (Qi )+ (p(Qi ) − c)+ qij p0 (Qj )−Qi p (Qi )
∂mi
∂mi
∂mi
∂mi



∂mi
∂qij
∂Qi
∂Qi
− k 0 (mi )+ −Qi p0 (Qi )+ mi qii p0 (Qi )+(p(Qj ) − c)
∂mi
∂τi
∂mj
∂mj

∂qii
∂Qj
∂qij
∂mj
+(p(Qi ) − c)+ qij p0 (Qj )+ (p(Qj ) − c)
.
∂mj
∂mj
∂mj
∂τi

∂Wi
=
∂τi τi =τj =0

By (9), Qi = Qj . This and (10), imply that qii = qjj = qij = qji , ∂Qj /∂mi = ∂Qi /∂mi and∂Qj /∂mj = ∂Qi /∂mj . The free entry condition (11) at no tax (τi = τj = 0) implies mi = mj .
Using these results, we obtain


∂Qi
∂Qi
∂Qi
∂qii
0
0
0
−Qi p (Qi )+ mi qii p (Qi )+ mj qji p (Qi )+ mi (p(Qi ) − c)
∂mi
∂mi
∂mi
∂mi


∂mi
∂qij
∂Qi
∂Qi
+(p(Qj ) − c)
− k 0 (mi )+ −Qi p0 (Qi )+ mi qii p0 (Qi )
∂mi
∂τi
∂mj
∂mj


∂Qi
∂qij
∂mj
∂qii
+mj qji p0 (Qi )+ mi (p(Qi ) − c)+ (p(Qj ) − c)
∂mj
∂mj
∂mj
∂τi


∂mi
∂qij
∂qii
+ (p(Qj ) − c)
− k 0 (mi )= mi (p(Qi ) − c)
∂mi
∂mi
∂τi


∂qii
∂qij ∂mj+ mi (p(Qi ) − c)+ (p(Qj ) − c).
∂mj∂mj ∂τi∂Wi=∂τi τi =τj =0

Proposition 1 (−∂mi /∂τi > ∂mj /∂τi > 0) and the properties used in Appendix A (∂qii /∂mi =20

∂qii /∂mj and ∂qij /∂mi = ∂qij /∂mj ) imply


∂qij
∂mi
∂Wi
∂qii
0
+ (p(Qj ) − c)− k (mi )> mi (p(Qi ) − c)∂τi τi =τj =0
∂mi
∂mi
∂τi



∂qii
∂qij
∂mi
+ mi (p(Qi ) − c)+ (p(Qj ) − c)
−
∂mj
∂mj
∂τi
∂mi
= −k 0 (mi )
> 0.
∂τi

Appendix C: Proof of Proposition 3.
Equations (9) and (10) imply that Qi = Qj , qii = qjj = qij = qji , mi = mj , ∂Qj /∂mi =∂Qi /∂mi , ∂Qj /∂mj = ∂Qi /∂mj , ∂Qi /∂mi = ∂Qi /∂mj , ∂Qj /∂mi = ∂Qj /∂mj , ∂qii /∂mi =∂qii /∂mj , ∂qjj /∂mi = ∂qjj /∂mj , ∂qij /∂mi = ∂qij /∂mj , ∂qji /∂mi = ∂qji /∂mj , and −∂mi /∂τi >∂mj /∂τi > 0 (−∂mj /∂τj > ∂mi /∂τj > 0). When each government chooses the tax rate simultaneously, the first-order condition for country j is given by



∂Qj
∂qjj
∂Qi
∂Qj
−Qj p (Qj )+ mj qjj p0 (Qj )+ (p(Qj ) − c)+ qji p0 (Qi )
∂mi
∂mi
∂mi
∂mi


∂qji
∂mi
∂Qj
+(p(Qi ) − c)+ −Qj p0 (Qj )+ (p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj )
∂mi
∂τj
∂mj


∂Qj
∂qjj
∂Qi
∂qji
∂mj
0
0
0
+ (p(Qj ) − c)+ qji p (Qi )+ (p(Qi ) − c)− k (mj )+mj qjj p (Qj )
∂mj
∂mj
∂mj
∂mj
∂τj

∂Wj
=
∂τj

0

= 0.

Using the properties given at the top of this appendix, we obtain
∂Wj
∂τj


∂qjj
∂qji ∂mi= mj (p(Qj ) − c)+ (p(Qi ) − c)∂mi∂mi ∂τj



∂qjj
∂qji
∂mj
0
+ (p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj ) + mj (p(Qj ) − c)+ (p(Qi ) − c)− k (mj )
∂mj
∂mj
∂τj



∂qjj
∂qji
∂mj
> mj (p(Qj ) − c)+ (p(Qi ) − c)
−
∂mi
∂mi
∂τj



∂qjj
∂qji
∂mj
0
+ (p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj ) + mj (p(Qj ) − c)+ (p(Qi ) − c)− k (mj )
,
∂mj
∂mj
∂τj

0=

21

which simplifies to

0 > [(p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj ) − mj k 0 (mj )]

∂mj
.
∂τj

Because ∂mj /∂τj < 0, we now have that
0 < (p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj ) − mj k 0 (mj ).

(C1)

In a symmetric equilibrium,∂Wj∂τi symmetric equilibrium


∂qjj
∂Qi
∂Qj
∂Qj
0
+ mj qjj p0 (Qj )+ (p(Qj ) − c)+ qji p0 (Qi )= −Qj p (Qj )
∂mi
∂mi
∂mi
∂mi


∂qji
∂mi
∂Qj
+(p(Qi ) − c)+ −Qj p0 (Qj )+ (p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj )
∂mi
∂τi
∂mj


∂mj
∂Qj
∂qjj
∂Qi
∂qji
0
0
0
+mj qjj p (Qj )+ (p(Qj ) − c)+ qji p (Qi )+ (p(Qi ) − c)− k (mj )
.
∂mj
∂mj
∂mj
∂mj
∂τi
Use the properties of symmetry to simplify the above as∂Wj∂τi symmetric equilibrium
∂qji ∂mi∂qjj> mj (p(Qj ) − c)+ (p(Qi ) − c)∂mi∂mi ∂τi



∂qjj
∂qji
∂mi
+ mj (p(Qj ) − c)+ (p(Qi ) − c)
−
∂mj
∂mj
∂τi
∂mj
∂τi
∂mj
= [(p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj ) − mj k 0 (mj )]∂τi+ [(p(Qj ) − c)qjj + (p(Qi ) − c)qji − k(mj ) − mj k 0 (mj )]> 0.

The last inequality comes from (C1) and ∂mj /∂τi > 0.

Appendix D: Proof of Proposition 4.
22

We use (14) to derive the effect of corporate tax on the number of firms. Define Φ and Ψiby

∂φw /∂me ∂φw /∂mw − k/[2(1 − τw )]Φ≡∂φe /∂mw∂φe /∂me − k/[2(1 − τe )]
−2φw /(1 + M ) + Ψe
 −2φw /(1 + M ) − k/[2(1 − τw )]=
−2φe /(1 + M ) + Ψw
−2φe /(1 + M ) − k/[2(1 − τe )]
and
Ψi ≡

2nt2 (1 + 2mi ).
(1 + M )2

From these expressions, we obtain








kmi
 ∂mi /∂τi 
 −2φj /(1 + M ) − k/[2(1 − τj )] 

=

.
2
2
det(Φ)(1−τ)
i∂mj /∂τi
2φj /(1 + M ) − Ψi

(D1)

In the first stage, each government chooses the tax rate, taking the other government’s tax rate
as given and anticipating the responses of firms (described in (D1)). Maximization of national
welfare
n
Wi =
2



M − tmj
1+M

2

( 
)

2
2
1 + tmj
1 − t(1 + mj )kmi
+ mi n
+n
−
.
1+M
1+M
2

(D2)

gives the first-order condition for country i:




ξi2
∂mi
ξi3
∂mj
∂Wi
2ξi1
2ξi1
0=
= −
+
− kmi
+ −
+
.
3
2
3
2
∂τi
(1 + M )(1 + M )∂τi(1 + M )(1 + M )
∂τi

23

(D3)

whereξi1 ≡ n(M − tmj )2+ mi (1 + tmj )2 + mi [1 − t(1 + mj )]22
ξi2 ≡ n M − tmj + (1 + tmj )2 + [1 − t(1 + mj )]2
ξi3 ≡ n (1 − t)(M − tmj ) + 2t2 mi (1 + 2mj ) .

Equation (D3) simplifies to


2ξi1
ξi2
−
+
− kmi
3
(1 + M )(1 + M )2



k
2φj
+
1+M
2(1 − τj )





2ξi1
ξi3
= −
+
3
(1 + M )(1 + M )2




2φj
− Ψi .
1+M(D4)

Note that τe = τw = 0 leads to the symmetric number of firms mw = me = M/2.
Now, evaluating ∂Wi /∂τi at τw = τe = 0, we obtain



∂Ww
sgn
= sgn [Ξ]∂τw τw =τe =0

(D5)

where
(



3M − 1Ξ ≡ k(1 + M )2 (1 + 3M ) + n M (7 + 4M ) t −M (7 + 4M )2

25M 2 + 22M + 1−
M (7 + 4M )).

A calculation yields
n (25M 2 + 22M + 1)
M (7 + 4M )24n(1 + 3M ) n (25M + 22M + 1)>−
M
M (7 + 4M )2n(23M + 78M + 27)=
M (7 + 4M )

Ξ ≥ k(1 + M )2 (1 + 3M ) −> 0.

The second inequality comes from k(1 + M )2 > 4n/M using the first-order condition (14).12 From
12

Summing up the zero profit conditions for two countries after substituting τw = τe = 0, we obtain thatkM/2 = φw + φe > 2n/(1 + M )2 .

24

(D5), we have∂Ww
> 0.
∂τw τw =τe =0

Appendix E: The existence and uniqueness of symmetric Nash equilibrium of the tax game.
Assume no trade cost. Taking the limit of t → 0 yield Ψi = 0, ξi1 = nM 2 /2+N mi , ξi2 = nM +Nand ξi3 = nM . Then, by (14), (D4) can be written as


ξi2
2ξi1
−
+
− kmi
3
(1 + M )(1 + M )2



mj
1
+
2 1+M






2ξi1
mj
ξi3
= −
+
3
2
(1 + M )(1 + M ) 1 + M

which simplifies toN (1 + 3mj − mi ) + nM
2mj
= kmi 1 +.
(1 + M )3
1+M

(E1)

First, we show that the first order condition (E1) determines (τwo , τeo ) uniquely. Subtracting (E1)of West from that of East, we obtain4N+ k (mw − me ) = 0.
(1 + M )3

Because the bracketed term is positive, mow = moe = M/2. Substituting me = mw into (E1), we
obtaink=N (1 + 3mw ).
mw (1 + 2mw )2 (1 + 4mw )(E2)

The right hand side of (E2) is decreasing in mw . Hence, given k < 4N/45, it has the uniquesolution for mw > 0, which determines (mow , moe ) uniquely. Substituting t = 0 into (14), and using
the fact that (mow , moe ) is unique and me = mw , we can determine (τwo , τeo ) uniquely and τwo = τeo .
Next, we show that Ww |τe =τeo is quasi-concave in τw . The second derivative of Ww |τe =τeo withrespect to τw at (τwo , τeo ) (and hence at (mow , moe )) is given by
k 2 M (1 + M )2 [4k 2 M (1 + M )5 + σ1 + σ2 + σ3 ]
d2 
W
|
=
−
w τe =τeodτw2
8(1 − τwo )[k(1 + M )3 + 8N (1 − τwo )]3

25

(E3)

whereσ1 ≡ k 2 M 2 (1 + M )5 (16 + 13M ),σ2 ≡ −8N 2 (1 − τwo )(4 + M )(1 + 3M ),
σ3 ≡ kN (1 + M )2 −4 + M (21 − 32τwo ) + M 2 [151 + 158M − 152τwo (1 + M )] .
Here, use has been made of the fact that mow = moe = M/2. This fact allows the free entry condition(14) and the first order condition (E1) to be rewritten

4N (1 − τwo ) = kM (1 + M )2 ,
3M
2kM (1 + M ) (1 + 2M ) = 2N 1 +.
2
Substituting these into σ1 and σ2 yields

σ1 =2N kM (1 + M )3 (16 + 13M )(1 + 3M/2)
1 + 2M

σ2 = −2N kM (1 + M )2 (4 + M )(1 + 3M ).

Hence,
σ1 + σ2 =2N kM (1 + M )2 {24 + M [64 + M (55 + 27M )]}> 0.
2 + 4M(E4)

Moreover, since mow = moe > 1, the total number of firms M is larger than 2. Hence,
σ3 > kN (1 + M )2 −4 + M (21 − 32τwo ) + M 2 (6M − 1)
> kN (1 + M )2 [−4 + M (21 − 32τwo + 11M )]> kN (1 + M )2 [−4 + 11M (M − 1)]> kN (1 + M )2 (11M − 4) > 0.

26

(E5)

From (E3), (E4) and (E5), we have that
d2 
Ww |τe =τeo < 0.
dτw2
Because there exists the unique τwo that satisfies the first order condition dWw /dτw = 0 for τeo ,Ww (τw , τeo ) is quasi-concave in τw . Similar arguments hold for East.
Next, we check the behavior of dWw /dτw when τw → 1 or τw → −∞. For τeo given, it
follows from (14) that limτw →1 mw = 0, limτw →−∞ mw = +∞, limτw →1 me = m
b < +∞ andlimτw →−∞ me = 0 where mb is determined by
2N (1 − τeo ) = m(1 + m)2 .

Using (14), dWw /dτw |τe =τeo can be rearranged to yield



dWw
kN
N (1 + 3me − mw ) + nM
2me=−
+ kmw 1 +dτw τe =τeo
(1 − τeo )(1 + M )3
1+M


−1
2N
1+M
k(1 + M )
×
+
m
+
.
w
1+M
1 − τeo2
From this, we obtain
dWw
dWw
=
lim
τw →1 dτw
(mw ,me )→(0,m)
bdτw τe =τeo
τe =τeolim=−

kN 2 (2 + 7m)
b
< 0.
2
3
(1 + m)b [k(1 + m)
b + 4N (1 − τeo )]

and
dWw
dWw
=
lim
= 0.
τw →−∞ dτw(mw ,me )→(+∞,0) dτw τ =τ oτe =τeoeelim

These two conditions and quasi-concavity of Ww (τw , τeo ) imply that Ww (τw , τeo ) is maximized at τwo .
In other words, (τwo , τeo ) is a Nash equilibrium of the tax game.
It remains to consider the cases of corner solutions in which one country has no firms (mi = 0).
Two cases can arise. In one, a country sets a tax rate so high that it loses all firms. Clearly, such27

a strategy is never optimal for this country. In the other, a country gives such a high subsidy thatit gets all firms. Again, this cannot happen in equilibrium because the other government would
reduce its tax rate. Thus, (τwo , τeo ) is the unique Nash equilibrium of the tax game.

Appendix F: Autarky with linear functions.
In this appendix, we characterize the equilibrium allocation under autarky. Cournot competition leads to the output and price levels of

q=

n
,
1+m

mn
,
1+m

Q=

p=

1
.
1+m

(F1)

The profit (2) of a firm then becomes as
π = n(1 − τ )

1
1+m

2
−

km
.
2

The zero profit condition π = 0 in the second stage determines the number of firms for a given
corporate tax:k=2n(1 − τ ).
m(1 + m)2

(F2)

In the first stage, each government maximizes the welfare function (12) with respect to τ subject
to the balanced-budget constraint sn = mnτ /(1 + m)2 . By (F2), corporate taxation reduces thenumber of firms (∂m/∂τ < 0). Substituting (F1) and sn = mnτ /(1 + m)2 into (12), we obtainnm  km1+−.
W =m(1 + m)2
2
2(F3)

By (F2), the number of firms m is a function of tax rate τ , which makes welfare in (F3) a functionof τ . Taking ∂m/∂τ < 0 into consideration, the first-order condition of welfare maximization
yieldsτa = 1 −1
2(1 + ma )where ma is determined byk=nma (1 + ma )3
28

.

(F4)

Since there are more than one firm in the equilibrium, (F4) implies that n ≥ k (i.e., N ≥ 2k),
which in turn implies that the equilibrium tax rate is positive (τ a > 0). It is straightforward that
this allocation is optimal.

Appendix G: Proof of Proposition 5.
Calculations show that mi ≥ 1 in the closed economy (resp. in the open economy) if and only
if N ≥ λa k (resp. N ≥ λo k) where λa ≈ 16 (resp. λo ≈ 11.25). Therefore, we focus on the intervalN/k ∈ [16, +∞) so that the number of firms is larger than one in both economies.
Equations (F3) and (D2) are rearranged asWia =N ma (2 + ma ) k(ma )2−4(1 + ma )2
2

(G1)

Wio =

N mo (1 + mo ) k(mo )2−.
(1 + 2mo )2
2

(G2)

and

In the followings, we show (A) that Wio > Wia when N is small and is equal to 16k, but (B)that the result is reversed when N goes to infinity.
When N is equal to 16k, (E2) and (F4) yield ma = 1 and mo ≈ 1.1571, respectively. These
numbers of firms lead to thatWio
≈ 1.186.
Wia
which shows claim A above.
As for claim B, we first show how ma and mo diverge when N goes to infinity. Define δ a andδ o as12m(1 + m)3
1 + 3mδo ≡.
m(1 + 2m)2 (1 + 4m)

δa ≡Then, (E2) and (F4) are represented as k/N = δ a and k/N = δ o , respectively. Noting that bothδ a and δ o are decreasing in m and that, δ o − δ a = {1 + 4m + 2m2 [2 + m(2 + 3m)]}/[2m(1 + m)3 (1 +29

2m)2 (1 + 4m)] > 0 for all m > 0, we readily know thatmo > ma .

Let ma be the solution of k/N = 1/(2m4 ) (i.e., ma = [N/(2k)]1/4 ). From the fact that δ a −1/(2m4 ) = [m3 − (1 + m)3 ]/[2m4 (1 + m)3 ] < 0 for all m > 0, we obtain.

ma < ma .

(G3)

Let mo be the solution of k/N = 1/(1 + 4m)3 (i.e., mo = (1/4)[(N/k)1/3 − 1]). Because δ o − 1/(1 +4m)3 = {1 + 2m[5 + 2m(9 + 11m)]}/[m(1 + 2m)2 (1 + 4m)3 ] > 0 for all m > 0, we know thatmo > mo .

(G4)

Next form this ratio
21/4
mo
=
ma
4

"

N
k

1/12


−

k
N

1/4 #and note thatmo= +∞.
N →+∞ malim

(G5)(G3) and (G4) imply that mo /ma > mo /ma . This and (G5) lead tomo= +∞N →+∞ malim

Now rearrange (G1) and (G2) as
  a
Wia
N m (2 + ma ) (ma )2=−kk4(1 + ma )2
2
  o
o
o
Wi
N m (1 + m ) (mo )2=−,kk (1 + 2mo )2
2

30

(G6)

and define the following functions of m.
Nkm(2 + m) m2−
4(1 + m)2
2

N
k



m(1 + m) m2.
−(1 + 2m)22a

ω (m) ≡o

ω (m) ≡For a given N/k, a change in the number of firms leads to changes in ω(m) as
N/k + 2m − 6m2 − 6m3 − 2m4
ω (m) =
2(1 + m)3
N/k − m − 6m2 − 12m3 − 8m40.
ω o (m) =(1 + 2m)3a0

Moreover, the second derivatives are given as
3N/k + 2 + 8m + 12m2 + 8m3 + 2m4<02(1 + m)4
6N/k + 1 + 8m + 24m2 + 32m3 + 16m400
ω o (m) = −< 0.
(1 + 2m)400

ω a (m) = −(G7)

Evaluating the first derivative at equilibrium values of m, we obtain0ω a (ma ) = 0.

(G8)

Define Ωa as
a

Ω ≡



N
k



ma (2 + ma ) (ma )2−.
4(1 + ma )22

Then, equations (G3), (G7) and (G8) imply thatWia
− Ωa = ω a (ma ) − Ωa > 0.
k

31

(G9)

We also obtain(mo )2 (1 + 6mo )ω (m ) = −<0
1 + 5mo + 6(mo )2
1 + 11ma + 42(ma )2 + 52(ma )3 − 8(ma )40
ω o (ma ) =(1 + 2ma )3
o0

o

(G10)

< 0 for a sufficiently large ma .

Define Ωo as
0



Ω ≡

N
k



mo (1 + mo ) (mo )2.
−(1 + 2mo )22

Note that limN →+∞ ma = +∞. Then, equations (G4), (G5), (G7) and (G10) yieldWio− Ωo = ω o (mo ) − Ωo < 0
k

(G11)

for a sufficiently large N . Equations (G9) and (G11) imply that
Wio Wia−< Ωo − Ωa for a sufficiently large N.
kk
Substituting ma = [N/(2k)]1/4 and mo = (1/4)[(N/k)1/3 − 1] into Ωo − Ωa , we obtain
 "
#2
r



 1/3
1/3
1/3
8(N/k)
(N/k)
−
1
(N/k)
+
3
1
N
2N
Ωo − Ωa =
−
−1 +8
+
2
32 
k
k
[(N/k)1/3 + 1]
)
823/4 (N/k)5/4 23/4 (N/k)1/4 + 4−.
2[23/4 (N/k)1/4 + 2]
A calculation show thatlim (Ωo − Ωa ) = −∞.

N →+∞Then (G12) implies that

lim

N →+∞

Wio Wia
−
k
k


= −∞

and hencelim (Wio − Wia ) = −∞.

N →+∞

32

(G12)

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33

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34

M o M **
1.35
1.30
1.25
1.20
1.15
1.10
1.05
t
0.05

0.10

0.15

0.20

0.25

(a)Trade cost and the degree of excess entry

Wio -Wia
0.5
0.4
0.3
0.2
t=0
0.1

t=0.001

t=0.0250.0

n20
t=0.05

40

60

80

100

120

140

160

-0.1

(b)Trade cost and the impact of trade on welfare-(I)Wio -Wia
n=30
t
0.02

0.04

0.06

0.08

0.10

n=70
-1

-2
n=100
-3

-4

(c)Trade cost and the impact of trade on welfare-(II)Wio - Wia
n
0.06

0.04

0.02
t=0
0.00

n
20

40

60

80

100

120

140
160
t=0.001
t=0.025-0.02

t=0.05(d)Trade costs and the impact of trade on welfare per capita
Figure 1. Eects of trade cost
Notes: In all gures, we set k = 1 (i.e., ki = mi /2). In (a), we set n = 20.

mw  meΘ  H1 - ΘL
1.0
0.9
0.8
0.7
0.6
0.5

0.55

0.60

0.65

0.70

0.75

Figure 2. The reverse home market eect

0.80

Θ

Τ
0.70

0.65

Dashed line: small country

0.60

0.55

0.50
0.50

Solid line: large country

0.55

0.60

0.65

0.70

0.75

0.80

Θ

Figure 3. Dierence in the tax rate between asymmetric countries

Wio -Wia

1.0
Dashed line: small country
0.5

Solid line: large country
0.55

0.60

0.65

0.70

0.75

0.80

Θ

-0.5

(a) Asymmetry and the impact of trade on welfare

Wio - Wia
ni
0.20

0.15

0.10
Dashed line: small country
0.05
Solid line: large country
0.55

0.60

0.65

0.70

0.75

0.80

Θ

(b) Asymmetry and the impact of trade on welfare per capita

Figure 4. Dierence in the impact of trade on welfare between asymmetric countries