Subsidizing firm entry in open economies

Entrepreneurs who decide to start a business are faced with different levels of effective entry costs in different countries. These costs are heavily influenced by economic policy through entry regulation and subsidies. In this paper we present a two-country general equilibrium model with monopolistic competition and heterogeneous firms where entrants pay a sunk cost and randomly draw their productivity level. Governments collect lump-sum taxes and subsidize these sunk entry costs for the domestic entrepreneurs. One motive for this policy, valid already in autarky, is to tighten market selection. This selection effect leads to better firms that produce and sell more output at lower prices. In the open economy there is another, strategic motive for entry subsidies as the tightening of market selection leads to a competitive advantage for domestic producers in international trade. Our analysis shows that entry subsidies in the Nash-equilibrium are first increasing, then decreasing in the level of trade freeness. This implies a U-shaped relationship between trade freeness and effective entry costs. Comparing the non-cooperative and the cooperative policies, we furthermore show that there is first too much and then too little entry subsidization in the course of trade integration.