Industrial Blackmail of Local Governments

Abstract

A dynamic model of inter-governmental competition for investment is presented, where the investment represents a potentially large source of tax revenue for the local governments, and the local productivity of investment is uncertain. A single firm decides where to locate its new plant in each period by conducting an auction, soliciting bids from the local governments. Equilibrium subsidies from the local governments are derived, as well as conditions under which the firm will switch locations between periods. A second issue addressed in this paper is local government strategic investment in infrastructure. We consider a two-stage game in which local governments first choose a level of infrastructure (which is costly to build), then participate in the sequential auction described above. It is shown that, even if the costs of building the infrastructure are the same in each location, in equilibrium the local governments will choose different levels of infrastructure and the region which chooses the highest level will be better off. Moreover, when the level of infrastructure is endogenous in the manner described, federally administered programs designed to increase the level of infrastructure in the less attractive region will make the firm strictly better off, without necessarily increasing the payoffs to either of the two local governments.

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