Asymmetric Competition among Nation States: A Differential Game Approach

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.