City size, the Henry George theorem under monopolistic competition.

We analyze the equilibrium and the optimal resource allocations in a monocentric city under monopolistic competition. Unlike the constant elasticity of substitution (CES) case, where the equilibrium markups are independent of the city size, we present a variable elasticity of substitution (VES) case where the equilibrium markups fall with the city size. We then show that, due to excess entry triggered by such pro-competitive effects, the 'golden rule' of local public finance, i.e., the Henry George theorem (HGT), does not hold in the second best. We finally prove, within our framework, that the HGT holds in the second best if and only if: (i) the second-best allocation is first-best efficient, which turns out to be equivalent to the CES case; or (ii) a marginal change in the city size has no impact on equilibrium product diversity at the second best.