External Increasing Returns and Production Subsidies in the Case of a Large Country
David Franck

Abstract
The strict superiority of production subsidies to increasing returns to scale (IRS) sectors of a small open economy are not justified when these scale effects are driven by world outputs. This paper extends and compares the case of a small country to that of a large country. In a free-trade equilibrium, the national IRS sectors under produce relative to their Pareto optimal levels, calling for a production subsidy to these sectors. Monopoly power of the large country calls for taxation of all exported goods. If some of the exports are subject to IRS, two opposing forces will be at work: the IRS effect will ask for an export subsidy, the terms-of-trade effect will call for export taxes. Hence for modern-day economies the case for state intervention, even in the presence of the externality inherent in external increasing returns, has been exaggerated: it is at best weak for a large country.

Full Text: PDF