INEFFICIENT LOCK‐IN AND SUBSIDY COMPETITION*

This article studies a subsidy game among two asymmetric regions in a new trade model. Capital can freely move among regions, but capital rewards are repatriated to the region of residence. The activity of the modern sector is associated with positive spillovers. We study subsidy competition, starting from an equilibrium where the industry core is inefficiently locked in to the smaller region. When regions weigh workers’ and capitalists’ welfare equally, subsidy competition results in a relocation of industry to the larger region, restoring an efficient allocation. When workers’ welfare is weighted more heavily, the smaller (core) region may pay subsidies that are high enough to prevent a relocation of industry.