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Interjurisdictional competition with adverse selection

Author

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  • Ruben Hernandez-Murillo
Abstract
In this paper we study competition among non-benevolent local governments for mobile firms and evaluate the consequences of imposing alternative regimes of competition. In our model politicians act as regulators that offer incentives in the form of recommended output levels and socially-costly transfers to induce firms, which have private information on their costs, to operate in their community. Politicians fail to estimate correctly the social costs of public funds and competition drives firms' information rents to higher levels than under a cooperative regime. Therefore, from the perspective of a benevolent federation, aggregate welfare is reduced and constitutional constraints on the competition process may be desirable. Imposing a system of coarser policy instruments improves welfare, even when politicians are benevolent, because it reduces the costly rents that are granted to firms in equilibrium ?at the cost of distorting output choices. We find that gains from resorting to constitutional constraints are maximal when communities are identical, but if the extent of asymmetry between locations increases, the advantages of the constrained regime decrease and can be overturned, because it prevents the more productive locations from attracting the more efficient firms.

Suggested Citation

  • Ruben Hernandez-Murillo, 2012. "Interjurisdictional competition with adverse selection," Working Papers 2012-052, Federal Reserve Bank of St. Louis.
    • Handle: RePEc:fip:fedlwp:2012-052
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    More about this item

    Keywords

    Fiscal policy; Public goods;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • H20 - Public Economics - - Taxation, Subsidies, and Revenue - - - General
    • H32 - Public Economics - - Fiscal Policies and Behavior of Economic Agents - - - Firm
    • H73 - Public Economics - - State and Local Government; Intergovernmental Relations - - - Interjurisdictional Differentials and Their Effects
    • R38 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Real Estate Markets, Spatial Production Analysis, and Firm Location - - - Government Policy
    • R50 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - Regional Government Analysis - - - General

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