Interjurisdictional Competition with Adverse Selection

Abstract

In this paper, we study the welfare consequences of imposing alternative regimes of competition between two non-benevolent local governments that compete for mobile firms which have private information on their degree of locational attachment or home bias. In an environment in which politicians fail to internalize correctly the social costs of public funds, competition among jurisdictions raises the firms' information rents to higher levels than if jurisdictions were to cooperate. Therefore, from the perspective of a benevolent federation, constitutional constraints on the competition process may be desirable. We find that imposing a system of coarser policy instruments may improve welfare relative to competition with discretionary instruments, 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 also find that the gains from resorting to constitutional constraints are maximal when communities are identical, but if the extent of asymmetry between locations (in terms of local market size or technological complementarities) increases, the advantages of the constrained regime decrease and can be overturned.