Strategic Fragmentation and Production Subsidies∗

In this paper, we examine the welfare properties of strategic fragmentation under production subsidies. We first consider a case in which a production subsidy rate is given exogenously. We show that, under the fixed subsidy policy, firms choose fragmentation despite the domestic production being socially desirable. Next, we examine a situation in which the government chooses a production subsidy rate optimally. In this case, we show that fragmentation is always socially desirable. This implies that the socially undesirable fragmentation does not arise under the optimal production subsidy policy. JEL classification: F12, F23