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An optimal incentive contract to avert firm relocation

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  • Pollrich, Martin
  • Schmidt, Robert

Abstract

In a globalized economy, firms move production to other countries without turning a hair. A local policy maker who seeks to avert relocation faces a dynamic problem - incentivizing the firm to remain in its home country today does not guarantee that the firm also stays in the future. We investigate situations where contracts between a local regulator and the firm can be written on some contractible productive activity, e.g. labor, output, or the firm's emissions. The firm undertakes a location-specific investment that is not contractible. When long-term contracts are feasible, the regulator averts relocation by postponing a sufficient amount of transfer to the second period. With limited commitment, i.e. when only short-term contracts are feasible, contracts with positive transfers in the second period cannot be implemented if the firm's investment is unobservable to the regulator. The regulator can avoid this problem by a tighter regulation in the first period. This induces the firm to invest more, which creates a `lock-in effect' that prevents relocation without transfers in period 2. An important application of our model is in the area of climate policy, where firm relocation can be triggered via a unilateral introduction of an emissions price by a country.

Suggested Citation

  • Pollrich, Martin & Schmidt, Robert, 2014. "An optimal incentive contract to avert firm relocation," Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100314, Verein für Socialpolitik / German Economic Association.
  • Handle: RePEc:zbw:vfsc14:100314
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    References listed on IDEAS

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    1. Markusen James R. & Morey Edward R. & Olewiler Nancy D., 1993. "Environmental Policy when Market Structure and Plant Locations Are Endogenous," Journal of Environmental Economics and Management, Elsevier, vol. 24(1), pages 69-86, January.
    2. Xavier Freixas & Roger Guesnerie & Jean Tirole, 1985. "Planning under Incomplete Information and the Ratchet Effect," Review of Economic Studies, Oxford University Press, vol. 52(2), pages 173-191.
    3. Schmidt, Robert C. & Heitzig, Jobst, 2014. "Carbon leakage: Grandfathering as an incentive device to avert firm relocation," Journal of Environmental Economics and Management, Elsevier, vol. 67(2), pages 209-223.
    4. Bergemann, Dirk & Hege, Ulrich, 1998. "Venture capital financing, moral hazard, and learning," Journal of Banking & Finance, Elsevier, vol. 22(6-8), pages 703-735, August.
    5. Rey, Patrick & Salanie, Bernard, 1990. "Long-term, Short-term and Renegotiation: On the Value of Commitment in Contracting," Econometrica, Econometric Society, vol. 58(3), pages 597-619, May.
    6. Horstmann, Ignatius J. & Markusen, James R., 1992. "Endogenous market structures in international trade (natura facit saltum)," Journal of International Economics, Elsevier, vol. 32(1-2), pages 109-129, February.
    7. Joskow, Paul L, 1987. "Contract Duration and Relationship-Specific Investments: Empirical Evidence from Coal Markets," American Economic Review, American Economic Association, vol. 77(1), pages 168-185, March.
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    More about this item

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation

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