Optimal Regulation and Country Size

Abstract

This paper studies the relationship between country size and the optimal regulatory policy of firms with market power derived from research and development. In equilibrium, smaller countries allow less exploitation of market power by innovating firms because smaller countries are more able to free ride upon the incentives to research and development afforded by larger countries. The free-rider problem implies that the Nash equilibrium in government policies is inefficient; thus, there is an incentive for governments to coordinate their policies. Finally, the model is used to explain past and present regulation of the pharmaceutical industry in Canada. This paper studies the relationship between country size and the optimal regulatory policy of firms with market power derived from research and development. In equilibrium, smaller countries allow less exploitation of market power by innovating firms because smaller countries are more able to free ride upon the incentives to research and development afforded by larger countries. The free-rider problem implies that the Nash equilibrium in government policies is inefficient; thus, there is an incentive for governments to coordinate their policies. Finally, the model is used to explain past and present regulation of the pharmaceutical industry in Canada.