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Interjurisdictional competition with adverse selection

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  • Rubén Hernández-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.

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Bibliographic Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2012-052.

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Date of creation: 2012
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Handle: RePEc:fip:fedlwp:2012-052

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Keywords: Fiscal policy ; Public goods;

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  1. Larry Epstein & Michael Peters, 1996. "A Revelation Principle For Competing Mechanisms," Working Papers peters-96-02, University of Toronto, Department of Economics.
  2. Becker, Gary S & Mulligan, Casey B, 2003. "Deadweight Costs and the Size of Government," Journal of Law and Economics, University of Chicago Press, vol. 46(2), pages 293-340, October.
  3. Spulber, Daniel F., 1989. "Product variety and competitive discounts," Journal of Economic Theory, Elsevier, vol. 48(2), pages 510-525, August.
  4. Ray Owens & Pierre-Daniel Sarte, 1999. "Analyzing firm location decisions : is public intervention justified?," Working Paper 99-08, Federal Reserve Bank of Richmond.
  5. Stole, Lars A, 1995. "Nonlinear Pricing and Oligopoly," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 4(4), pages 529-62, Winter.
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