politics of competition for foreign direct investment: a ... i/i.d/m… · politics of competition...
TRANSCRIPT
Politics of Competition for Foreign Direct Investment: A
Simple Theory*
Jie Ma Economics Division
School of Social Sciences
University of Southampton
Southampton SO17 1BJ
United Kingdom
15 March 2005
Abstract
In this paper, we introduce domestic politics into the analysis of competition for
foreign direct investment (multinational) by two national governments. A government
is concerned with both social welfare and campaign contributions from special
interest groups. We show that though one country will gain more from the foreign
direct investment than the other country, and the multinational wants to locate in the
former country, the multinational will be attracted to the latter country if the latter
country’s government, which is driven by its domestic politics, can give the
multinational a sufficiently big offer. This implies that the allocation efficiency may
not be achieved. Given that two domestic politics driven governments compete for the
multinational. A Pareto welfare-worsening subsidy competition for foreign direct
investment in a strong sense occurs when the country, which gains less from the
foreign direct investment than the other country, and in which the multinational does
not want to locate, wins the competition for the multinational.
Key Words: Foreign direct investment (Multinational), Special interest politics,
Subsidy competition
JEL Classification: F23, D72
* This paper is competing to the Young Economist Award.
Politics of Competition for Foreign DirectInvestment: A Simple Theory∗
Jie Ma†
University of Southampton
15 March 2005
Abstract
In this paper, we introduce domestic politics into the analysis of competitionfor foreign direct investment (multinational) by two national governments. Agovernment is concerned with both social welfare and campaign contributionsfrom special interest groups. We show that though one country will gain morefrom the foreign direct investment than the other country, and the multinationalwants to locate in the former country, the multinational will be attracted to thelatter country if the latter country’s government, which is driven by its domesticpolitics, can give the multinational a sufficiently big offer. This implies thatthe allocation efficiency may not be achieved. Given that two domestic politicsdriven governments compete for the multinational. A Pareto welfare-worseningsubsidy competition for foreign direct investment in a strong sense occurs whenthe country, which gains less from the foreign direct investment than the othercountry, and in which the multinational does not want to locate, wins thecompetition for the multinational.
Key Words: Foreign direct investment (Multinational), Special interest pol-itics, Subsidy competition
JEL Classification: F23, D72Very Preliminary and Comments Welcome.
∗I am especially grateful to my supervisors, Robin A. Mason and Jian Tong, for guidance andadvice. Thanks also go to Thierry Verdier, who introduces me into the research field of politicaleconomy of trade policy. The discussions with Alistair M. Ulph and Juuso Välimäki are also helpful.The financial supports from the ORS Award Scheme, which the reference number is 2002037001,and from the University of Southampton are gratefully acknowledged. Of course, all the remainingerrors are my own.
†Mailing Address: Economics Division, School of Social Sciences, University of Southampton,Highfield, Southampton SO17 1BJ, UK. E-mail: [email protected].
1
1 Introduction
1.1 Motivation and the main results
Competition for foreign direct investment (multinational) among different countriesis a stylized fact, which is well documented by, e.g., UNCTAD (1996), Oman (2000).The Table III.6 of UNCTAD (1996) gives examples of foreign direct investment andfinancial incentives in the EU.
City, Country Year Company O ther lo cations Total state Company Financia l
considered financia l investment incentives
incentives (m illion $) p er job ($)
(m illion $)
New Castle upon 1995 S iem ens Austria, G ermany, 76 .92 1428 .6 51,820
Tyne, UK Ire land , Portugal,
S ingapore
Hambach , 1995 Mercedes-Benz, Austria, B elg ium , 111 370 n/a
Lorraine , Swatch Czech Republic ,
France Germany, Ita ly,
Sw itzerland
Castle B romw ich 1995 Jaguar Detro it, USA 128.72 767 128 ,720
B irm ingham ,
Whitley, UK
North-East England 1994/95 Sam sung France, Germany, 89 690.3 29,675
Portuga l, Spain,
Setuba l, Portugal 1991 Ford, UK, Spain 483.5 2603 254 ,451
Volkswagen
Table 1: Examples of foreign direct investment and financial incentives in the EU
It is not a surprise that many researchers keep their eyes on these competitions.However, though there have been voluminous papers studying the competition forforeign direct investment, almost all of these researches assume that governmentsseek to maximize national welfare, and study the strategic interactions between gov-ernments. However, this game (at least sometimes) is played by sovereign countries,and is a kind of international relation. According to Putnam (1988), internationalrelations are seen as a two-level games:
“The politics of many international negotiations can usually be con-ceived as a two-level game. At the national level, domestic groups pursue
2
their interests by pressuring the government to adopt favorable policies,and politicians seek power by constructing coalitions among those groups.At the international level, national governments seek to maximize theirown ability to satisfy domestic pressures, while minimizing the adverseconsequences of foreign developments. Neither of the two games can beignored by central decision-makers, so long as their countries remain in-terdependent, yet sovereign.” (Putnam (1988), pp. 434.)
In the context of competition for foreign direct investment, we think that priorto the stage during which governments engage in some form of competition for for-eign direct investment, there should be a stage during which political competitionbetween different pressure groups, or special interest groups in each country shapesthe government’s objective, given the special interest groups’ anticipations on howthe special interest groups in the other countries shape their governments’ objectivesrespectively, and the equilibrium outcome of the subsequent competition for foreigndirect investment. And it is nature to ask the following questions.
In the positive aspect, how does politics affect the allocation efficiency of theforeign direct investment? Allocation efficiency requires that the multinational locatesin a country such that the profits the multinational would earn in that country andthat country’s benefits from foreign direct investment are jointly maximized. In thenormative aspect, what are the welfare effects of the competition for foreign directinvestment when politics does matter? In particular, is it possible to observe a Paretowelfare-worsening competition in a strong sense, i.e., all of the participants lose?
Since there have been very few researches, which address the above research ques-tions in a two-level game framework, this paper is attempted to fill this gap.
The basic idea is as follows. Foreign direct investment has income redistributioneffects in each country. Hence, in each country, the special interest groups who arethe gainers of this redistribution do have incentive to lobby the government to at-tract the foreign direct investment, whilst the special interest groups who are thelosers of this redistribution do have incentive to lobby the government not to attractthe foreign direct investment. The government’s objective is shaped by this politicalcompetition. Then the governments engage in the competition for foreign direct in-vestment. The winner of this competition, and the social welfare of each country aredetermined. Notice that when the special interest groups in each country engage inpolitical competition, they know that such kind of competition occurs in each of theother countries. Therefore, the optimal lobby behavior should based on the anticipa-tions on how the special interest groups in the other countries lobby their governmentsrespectively, and should take into account of what the equilibrium outcome of thecompetition for the foreign direct investment is, given lobby behavior is sunk. Thisidea is illustrated in Figure 1.
How do we put this idea to work? We consider the case where two countriescompete for one unit indivisible foreign direct investment (multinational). There is
3
Political
Competition
FDI
Competition
Redistribution Effects Redistribution Effects
Special Interest
Groups of Country 1
…
1 2 N1
Special Interest
Groups of Country 2
… 1 2 N2
Government
1
Government
2
The
Multinational
Figure 1: Illustration of the basic idea
a monopoly market of a homogenous good in each country. The only factor of pro-duction is labor, which is unionized, and the wage rate and employment level aredetermined in a Leontief model. Therefore, in each country, trade union welcomesthe multinational, because it can sell more labor and achieve more employment gains,whilst domestic firm does not welcome the multinational because the profits it re-ceives will decrease. Therefore, the redistribution effects of foreign direct investmentare characterized, and the gainer and loser of this redistribution are identified ineach country. How trade union and domestic firm shape the government’s objectivevia political competition in each country is modelled as a menu auction based onBernheim and Whinston (1986), and Grossman and Helpman (1994).1
1Notice that we treat trade union and domestic firm in each country as special interest groups.Lahiri and Ono (2004) point out that trade union who wants the government to stipulate that
the multinational purchase most their inputs from the local markets has incentive to lobby thegovernment, and the purpose is to maximize the income of the workers.Kayalica and Lahiri (2003) point out that almost all countries has well-organized local producers,
4
In particular, we consider a seven-player-and-five-stage game. In the first stageof the game, trade union and domestic firm in each country make political contri-butions contingent on whether the multinational is attracted to this country by thegovernment. Then the two governments compete for the multinational, and the policyinstrument used is a lump-sum subsidy (tax). In the third stage, the multinationalmakes its location decision, and the possible option of direct export is not consid-ered in this model. Then in each country, the wage rate and employment level aredetermined. Follows the product market competition.
We solve this model and the main results are as follows:
1. Though one country will gain more from the foreign direct investment thanthe other country, and the multinational wants to locate in the former country,the multinational will be attracted to the latter country if the latter country’sgovernment, which is driven by its domestic politics, can give the multinationala sufficiently big offer. This implies that the allocation efficiency may not beachieved.
2. Other things being equal, one country will win the competition for the multina-tional when its government is more influenced by domestic political competitionthan the government of the other country.
3. In the case where there is policy of minimum wage rate in each country, otherthings being equal, one country will win the competition for the multinationalwhen the minimum wage rate prevailing in this country is lower than thatprevailing in the other country.
4. Given that two domestic politics driven governments compete for the multi-national. A Pareto welfare-worsening subsidy competition for foreign directinvestment in a strong sense occurs when the country, which gains less fromthe foreign direct investment than the other country, and in which the multi-national does not want to locate, is the winner country of the competition forthe multinational.
1.2 Related literatures
First, Grossman and Helpman (1995a) use the idea of a two-level game to study thenegotiation for a free-trade agreement between two countries. Grossman and Help-man (1996b) use the idea of a two-level game to study trade relations. Persson andTabellini (2000) use the idea of a two-level game to study international cooperationin fiscal policy.
e.g., automobile industry, who lobby the government for higher levels of protection against the goodsof foreign-owned plants producing in the country.
5
Next, how do we relate this research to other researches on politics and competi-tion for foreign direct investment?
Haaparanta (1996) uses a common agency model to consider competition for for-eign direct investment between two countries with unequal wage rate in order toachieve gains from employment creation. It supposes that the foreign firm allocatescapital between these two countries, so the choice there is a continuous one ratherthan a discrete one. The main results are as follows: the country with high wagerate may attract investment under subsidy competition in equilibrium; and what acountry pays more cannot warrant it a large share of investment.
It should be noted that in his paper, the two governments act as two principalsand the foreign firm, agent. Indeed, domestic politics is not considered. In addition,this paper assumes that each government maximizes a social welfare function, whichseems to be strange in a political economy research. These questions are consideredexplicitly in our paper.
Biglaiser and Mezzetti (1997) study the impact of elected officials’ re-election con-cerns on their decisions on whether to undertake new projects. The value of a projectto a jurisdiction depends in part on its elected official’s uncertain ability at providingsome public goods. The main results are as follows. The elected official’s willingnessto pay for the project differs from voters’ willingness to pay. If the incumbent officialexpects to lose (win) the election, then she is willing to pay more (less) than theproject’s total value to voters. Then they use the basic model to analyze the biddingwar for firms. Their analysis supports the view that a politician’s re-election concernshave an important effect on her decision making when competing for firms with othercountries or regions.
It should be noted that in this model the voters are assumed to be symmetric vis-à-vis the investment project; there are no conflicts of interest among them. However,in many instances, some citizens gain while others lose when an investment project isattracted. Therefore, as a political economy model, the power of their explanation isweakened. Notice that the income redistribution effects of foreign direct investmentare considered explicitly in our research.
Facchini and Willmann (2001) attempt to provide a general theory on politicaleconomy of international factor mobility. In a common agency framework, they showthat there exists strategic equivalence between tariffs and quotas. Then the model istested using 1995 OECD cross sectional data.
However, we wonder whether this model, which addresses broaden issues, is appro-priate for studying the case where several countries compete for one unit indivisibleforeign direct investment.
Finally, Facchini (2004) is the latest survey of the researches on political economyof international trade and factor mobility.
It should be noted there have been so many researches on the competition forforeign direct investment, from the viewpoint of tax competition, which assumes per-fect competition, whilst introduces asymmetries between countries, and studies the
6
interaction between different tax instruments, or from the viewpoint of industrialorganization, which assumes imperfect competition, and trade cost, market size, em-ployment gains, and technological transfer are the basic ingredients. Please refer toWilson (1999) for tax competition literatures. For industrial organization based re-searches, see, e.g., Haufler and Wooton (1999), Barros and Cabral (2000), Fumagalli(2003), etc.
1.3 The organization of the paper
This paper is organized as follows. section 2 sets out the model, which is character-ized as a seven-player-and-five-stage game. Next, the later four stages are analyzed.Section 4 studies the first stage. Then we do simple comparative statics analysis.The welfare effects are analyzed in section 6. In section 7, we compare the resultsderived and approach used in this paper with those in the received literatures, andthe final section concludes. Please refer to the Appendix A for technical proofs, andAppendix B for the summary of the main results obtained in industrial organizationbased research of competition for foreign direct investment.
2 The Model
We set out the model in this section.Preference:
There are two countries, i = 1, 2. The preference of the representative consumerof country i is given by
U i (qi, Ii) = ui (qi) + Ii,
where
ui (qi) = αiqi −1
2βiq
2
i .
qi is the consumption of a homogenous good, and Ii is the consumption of a numerairegood. The inverse market demand (market price) is given by
pi = αi − βiqi.
Production:
Labor is the only input for producing qi, and the technology is a Ricardian one:
qi =Li
γi,
where γi is the inverse of the input-output coefficient, and the marginal product oflabor is 1
γi. Therefore, if labor market is competitive, the real wage rate is wci =
1
γi.
We assume that labor is organized and form a trade union in each country.Players:
7
There are three firms: domestic firm of country 1, domestic firm of country 2,and a multinational firm; and two trade unions: trade union of country 1, and tradeunion of country 2; and two governments: government 1 and 2.
Timing:
This is a five-stage game.Stage 1: Trade union and domestic firm in each country simultaneously lobby the
government by giving the government contributions contingent on the location of themultinational. In particular, domestic firm i’s contribution schedule is given by
CFi =
{CFii if FDI in country i,CFij if FDI in country j;
where CFi ∈[0, C
F
i
]. I.e., firm i’s political contributions should be bounded, and
its greatest lower bound is zero, whilst its least upper bound is CF
i . Trade union i’scontribution schedule is given by
CTi =
{CTii if FDI in country i,CTij if FDI in country j;
where CTi ∈[0, C
T
i
]. I.e., trade union i’s political contributions should be bounded,
and its greatest lower bound is zero, whilst its least upper bound is CT
i . i = 1, 2,j = 1, 2, i �= j.2 Notice that we do not allow the multinational to make contributions.
Stage 2: Given the contributions schedules, the two governments simultaneouslyannounce a lump-sum subsidy bi to the multinational.3
Stage 3: The multinational makes its location choice. We suppose that the multi-national firm wants to establish a subsidiary at country 1 or 2.4
Stage 4: The wage rate and employment level are determined in each country.In particular, we assume that a trade union has full control over wage rate, whilst afirm (or firms) decides (decide) the employment level. We use a textbook model, i.e.,Leontief model, to characterize the strategic interactions in this stage.
Stage 5: Firms engage in product market competition, which is supposed a la
Cournot. We assume that if the multinational locates in country i, it would adoptthe same technology as that of firm i. Moreover, the firms will incur unit marketingcosts when selling their products. In particular, firm i’s marketing cost at country i isgiven bymi
i, whilst its marketing cost at country j is given bymij. The multinational’s
marketing cost at country i is given by mi, whilst its marketing cost at country j isgiven by mj.
Then the game is over.
2As we will see CF
i , and CT
i are well defined.3If bi is negative, it is a lump-sum tax.4We do not consider direct export as one of the multinational’s possible options.
8
Payoffs
A domestic firm maximizes the difference between its profits and its politicalcontributions. A trade union maximizes the difference between its employment gainsand its political contributions.
Government i maximizes
Gi =
{(1− ai)
(CFii + C
Tii
)+ ai (W i
i − bi) if FDI in country i,(1− ai)
(CFij + C
Tij
)+ aiW i
j if FDI in country j;
where ai ∈ (0, 1]. W ii is the social welfare in the case where country i wins the compe-
tition for the multinational, whilst W ij is the social welfare in the case where country
i loses the competition for the multinational. Social welfare is defined by the sumof (1) consumers’ surplus,5 (2) domestic firm’s profits, and (3) domestic employmentgains. In the case where country i wins the competition for the multinational, it paysa lump-sum subsidy bi to the multinational, which is collected from consumers bylump-sum taxation. The parameter ai evaluates the relative weight between politicalcontributions and net social welfare in the objective of government i. If ai ∈ (0, 1),government i prefers political contributions (tainted money) to net social welfare. Inthis case, government i is called a corrupted government. If ai = 1, government i isindifferent between political contributions (tainted money) and net social welfare. Inthis case, government i is called a benevolent government.6 Notice that ai serves asan index of the degree of corruption. A small value of ai represents a high degree ofcorruption, whilst a big value of ai represents a low degree of corruption.
The multinational maximizes the sum of its profits and the subsidy it receives.Therefore, imperfectly competitive market, competition for one unit indivisible
foreign direct investment, and political economy are the basic ingredients of thismodel.
Next, we analyze the simplest case, i.e., we assume that if the multinational locatesin country i, we have mi = m
ii, and m
ij = mj. In addition, the marketing cost at
country j is so high that it is not profitable for firm i, and the multinational to sell
5We assume that the workers do not consumer the good produced by themselves.6In general, we can write the objective function of government i as follows.
Gi =
{θi1(CFii +C
Tii
)+ θi2
[W ii −
(CFii +C
Tii
)− bi
]if FDI in country i,
θi1(CFij +C
Tij
)+ θi2
[W ij −
(CFij +C
Tij
)]if FDI in country j;
where θi1 ≥ θi2 > 0, i.e., the government i prefers tainted money to net social welfare in a weaksense. (See Grossman and Helpman (1994).) Maximizing Gi is equivalent to maximize
G′i =
{ (CFii +C
Tii
)+ θi2
θi1
[W ii −
(CFii +C
Tii
)− bi
]if FDI in country i,(
CFij +CTij
)+ θi2
θi1
[W ij −
(CFij +C
Tij
)]if FDI in country j.
We denote ai = θi2θi1
, where ai ∈ (0, 1]. Therefore, maximizing G′i is equivalent to maximize Gi, andai serves as an index of the degree of corruption. (See also Lahiri and Raimondos-Møller (2000),and Lahiri and Ono (2004).)
9
products in country j, i = 1, 2, j = 1, 2, i �= j. This motivates the supposition thatthe multinational wants to invest in one of the two countries rather than both of thetwo countries when the option of direct export is not feasible. This also implies thatthere is no trade between the two countries.7
We solve the model in section 3 and 4, and the solution concept is a SubgamePerfect Nash Equilibrium.
3 Equilibrium Analysis I: The Later Stages
Let us consider country i. When the multinational locates in this country, in the laststage of the game, the domestic firm maximizes its profits, which is given by
πii =(αi − βi
(qii + q
Mi
))qii − γiwiiqii −m
iiqii,
whilst the multinational maximizes its profits, which is given by
πMi =(αi − βi
(qii + q
Mi
))qMi − γiwiiq
Mi −m
iiqMi .
Notice that qii is the domestic firm’s sales in country i, qMi is the multinational’s salesin country i, and wii is the wage rate in the case where the multinational locates incountry i. Domestic firm’s first order condition for profit maximization and that ofthe multinational simultaneously determine the Nash equilibrium, which is given by
(qii, q
Mi
)=
(αi − γiwii −m
ii
3βi,αi − γiwii −m
ii
3βi
).
Hence, the optimal employment levels are given by
(Lii, L
Mi
)=
(γi
(αi − γiwii −m
ii
3βi
), γi
(αi − γiwii −m
ii
3βi
)),
where Lii is the employment level of firm i, and LMi is the employment level of themultinational.
7How do we explain the parameter of the marketing cost? Notice that it may serve as an index of“market structure.” There may have four “market structures”. First, there are two isolated market ifmij = mj are so high that it is not profitable for firms (firm), which locate (locates) in one country, to
sell products in the other country. It is the case that we will analyze. Second, mij is at a prohibitive
level, whilst mj is not. Hence, only the multinational can sell in the other market. Third, thoughthe two markets are segmented, all of the three firms can make sales in both of the two marketswith mi
i < mij . Four, we have an integrated market if the marketing costs for each of the three firms
in each market are the same.However, we wonder whether the basic results derived from the simplest case could be changed
when considering more complicated cases.(We can also motivate what the multinational invests in one of the two countries by introducing
a fixed investment cost into the model.)
10
In the next to the last stage, the trade union of country i maximizes its objectivefunction, i.e., its employment gains, which is given by
ωii = (wii − wci )(Lii + L
Mi
).
From the first order condition for maximization, we can solve the optimal wage rate,which is given by
wii =αi −m
ii + 1
2γi.
Using the expression for wii, we can show
qii = qMi =
αi −mii − 1
6βi,
Lii = LMi = γi
(αi −m
ii − 1
6βi
),
πii = πMi =
(αi −mii − 1)
2
36βi,
ωii =(αi −m
ii − 1)
2
6βi,
csii =(αi −m
ii − 1)
2
18βi,
W ii = cs
ii + ω
ii + π
ii =
(αi −mii − 1)
2
4βi.
Notice that csii is the consumers’ surplus in the case where the multinational locatesin country i.8
When the multinational locates in country j, in the last stage of the game, thedomestic firm maximizes its profits, which is given by
πij = (αi − βiqij) qij − γiwijqij −miiqij.
qij is domestic firm’s sales in the case where the multinational locates in country j,wij is the wage rate in the case where the multinational locates in country j. From
8Notice that qii, and qMi are not functions of γi respectively. Why is that? Recall that theproduction function is given by qi =
Liγi
. Therefore, to produce one unit of output requires γi unitsof labor, and the unit production cost is given by γi multiplied by the wage rate, which prevails. Inthis case, we consider competitive wage rate, which is equal to wci =
1
γi
. Hence, the unit production
cost is 1. Therefore, γi does not appear in the expressions for qii, and qMi respectively. This indicatesthat in this model, the unit production cost is one of the fundamental parameters. It happens to be1 in the case we consider. However, consider the case where country i adopts the policy of minimumwage rate, and the minimum wage rate is given by wi, which is strictly greater than the competitivewage rate. Now the unit production cost is given by γiwi. (Also see the later discussions.)
11
the first order condition for profit maximization, we can solve
qij =αi − γiwij −m
ii
2βi.
Hence, the optimal employment levels are given by
Lij = γi
(αi − γiwij −m
ii
2βi
),
where Lij denotes the employment level in the case where the multinational locatesin country j.
In the next to the last stage, the trade union of country i maximizes its objectivefunction, i.e., its employment gains, which is given by
ωij = (wij − wci )L
ij.
From the first order condition for maximization, we can solve the optimal wage rate,which is given by
wij =αi −m
ii + 1
2γi.
Notice that the wage rate is the same as that in the case where the multinationallocates in country i.9
9Notice that wii = wij . How do we understand this result?When the multinational locates in country i, trade union i maximizes employment gains: ωii =
(wii −wci )(Lii + L
Mi
). The first order condition for maximization can be written as follows:
wii −wci
wii=αi − γiwii −m
ii
γiwii.
Notice that the RHS is the inverse of the wage rate elasticity of labor demand.When the multinational locates in country j, trade union i maximizes employment gains: ωii =
(wii −wci )L
ij . The first order condition for maximization can be written as follows:
wij −wci
wij=αi − γiwij −m
ii
γiwij.
Notice that the RHS is the inverse of the wage rate elasticity of labor demand.Since the above two equations share the same functional forms, we must have wii = wij . Indeed,
we can show that the wage rate elasticity of labor demand is not dependent on the number of firms.Therefore, the equilibrium wage rate is not affected by the number of firms as well.
12
Using the expression for wij, we can show
qij =αi −m
ii − 1
4βi,
Lij = γi
(αi −m
ii − 1
4βi
),
πij =(αi −m
ii − 1)
2
16βi,
ωij =(αi −m
ii − 1)
2
8βi,
csij =(αi −m
ii − 1)
2
32βi,
W ij = cs
ij + ω
ij + π
ij =
7 (αi −mii − 1)
2
32βi.
Notice that csij is the consumers’ surplus in the case where the multinational locatesin country j.
We summarize the results in Table 2.
Term FDI NO WELFARE CHANGE
consumers’ surplus(αi−mi
i−1)
2
18βi
(αi−mii−1)
2
32βi
7(αi−mii−1)
2
288βi
employment gains(αi−mi
i−1)
2
6βi
(αi−mii−1)
2
8βi
(αi−mii−1)
2
24βi
domestic profits(αi−mi
i−1)
2
36βi
(αi−mii−1)
2
16βi−5(αi−mi
i−1)
2
144βi
social welfare(αi−mi
i−1)2
4βi
7(αi−mii−1)
2
32βi
(αi−mii−1)
2
32βi
Table 2: The redistribution effect of FDI in the basic model
Define
∆i =(αi −m
ii − 1)
2
βi, ∆j =
(αj −m
jj − 1
)2
βj.
Without loss of generality, in the following analysis we make the following assumption.
Assumption 1
∆i > ∆j.
In the third stage, the multinational makes its location choice. Given country i’slump-sum subsidy, bi, and country j’s lump-sum subsidy, bj, the multinational locatesin country i, if and only if
πMi + bi ≥ πMj + bj,
13
i.e.,bi +
(πMi − π
Mj
)≥ bj.
Otherwise, it will locate in country j. Notice that if bi = bj, it is more profitable forthe multinational to locate in country i since by Assumption 1,
πMi − πMj =
1
36(∆i −∆j) > 0.
Next, in the second stage, given the contribution schedules, government i’s objec-tive is given by
Gi =
{(1− ai)
(CFii + C
Tii
)+ ai (W i
i − bi) if FDI in country i,(1− ai)
(CFij + C
Tij
)+ aiW i
j if FDI in country j.
Notice that bi is the lump-sum subsidy, which is offered by government i. Setting,(1− ai
) (CFii + C
Tii
)+ ai
(W ii − bi
)=(1− ai
) (CFij + C
Tij
)+ aiW i
j ,
we can solve the best offer of country i, (maximum subsidy or minimum tax of countryi,) which is denoted by Si,10 where
Si =(1− ai)
ai
[(CFii + C
Tii
)−(CFij + C
Tij
)]+(W ii −W
ij
).
Therefore, given the governments’ anticipations of what the game would evolvefrom the second stage, and given contribution schedules, the equilibrium in this stageis characterized as follows: if
Si +1
36(∆i −∆j) ≥ Sj,
then country i wins the competition, and pays the amount bi = Sj − 1
36(∆i −∆j) to
the multinational. If
Si +1
36(∆i −∆j) < Sj,
country j wins the competition, and pays the multinational bj = Si+ 1
36(∆i −∆j).11
10Notice that the gross value of foreign direct investment to government i is given by[(1− ai
) (CFii +C
Tii
)+ aiW i
i
]−[(1− ai
) (CFij +C
Tij
)+ aiW i
j
]. However government i will pay
bi to the multinational when the multinational locates in country i. Since bi is col-lected from the consumers, from government i’s viewpoint, to attract the multinational costsaibi ≤ bi, given ai ∈ (0, 1]. Therefore, the net value of foreign direct investment to gov-ernment i is given by
[(1− ai
) (CFii +C
Tii
)+ aiW i
i
]−[(1− ai
) (CFij +C
Tij
)+ aiW i
j
]− aibi =[(
1− ai) (CFii +C
Tii
)+ ai
(W ii − bi
)]−[(1− ai
) (CFij +C
Tij
)+ aiW i
j
]. Let this expression be equal
to zero, we can solve the best offer of government i, which makes the net value of foreign directinvestment to government i be zero, and is equal to this net value over ai.Indeed, Si is a function of political contributions. Different Sis are associated with different
political contributions.11Here we assume implicitly that governments do not play (weakly) dominated strategies.
14
On the other hand, if country i wins the competition for the multinational, thenwe must have Si+ 1
36(∆i −∆j) ≥ Sj. Why is that? Suppose that country i wins the
competition however Si +1
36(∆i −∆j) < Sj. By the above analysis, if this was true,
then country j would win the competition. A contradiction. Using similar arguments,we can establish that if country j wins the competition for the multinational, thenwe must have Si + 1
36(∆i −∆j) < Sj.
In summary, in the second stage, country i wins the competition for the multina-
tional if and only if Si +1
36(∆i −∆j) ≥ Sj; country j wins the competition for the
multinational if and only if Si +1
36(∆i −∆j) < Sj.
How do we explain this? Notice that the second stage can be reinterpreted as afirst price auction under complete information. It is well known that a player winsthe auction if and only if this player has the highest valuation for the object.
4 Equilibrium Analysis II: The First Stage
Given the analysis of the later stages of the game, what is (are) equilibrium (equilib-ria) of the first stage? First notice
CF
i =5
144∆i, C
T
i =1
24∆i;
CF
i =5
144∆j, C
T
i =1
24∆j.
I.e., for each interest group, the least upper bound of political contributions is givenby the absolute value of the welfare change due to foreign direct investment.
Second notice that we must have
CTii ≥ 0, CFij ≥ 0, C
Fii = C
Tij = 0,
if 0 < ai < 1. The explanation is as follows: government i prefers political contri-butions to the net social welfare. Hence, the special interest groups want to rewardthe government if their favorable outcomes are realized respectively. In addition, aninterest group would help its rival if it contributed money to its unfavorable outcome.Of course, an interest group does not have incentive to do that.
Political contributions do not matter in the case where ai = 1 because governmenti is a benevolent government, which maximizes the social welfare.
Next we characterize the equilibria of the first stage of the game.
4.1 The case where 0 < ai < 1, 0 < aj < 1
In this case we have
Si =
(1− ai
ai
)(CTii − C
Fij
)+1
32∆i,
15
Sj =
(1− aj
aj
)(CTjj − C
Fji
)+1
32∆j.
We can establish the following results.
Lemma 1 Country i always wins the competition for the multinational, if and only
if Si +∆πM ≥ Sj at CTii =
1
24∆i, C
Fij =
5
144∆i, C
Tjj =
1
24∆j, C
Fji =
5
144∆j, i.e.,
(1
32+1
36
)(∆i −∆j) ≥
1
144
(1− aj
aj
)∆j −
1
144
(1− ai
ai
)∆i.
Proof. See Appendix.What is the story behind Lemma 1? The first two stages of the game could be
viewed as a delegated auction. In the government competition stage, country i wins
the competition for the multinational if and only if Si+1
36(∆i −∆j) ≥ Sj; country j
wins the competition for the multinational if and only if Si+1
36(∆i −∆j) < Sj. Every
interest group knows this. Hence, given other interest groups’ choices, any interestgroup has the very incentive to manipulate its government’s incentive by varying itspolitical contributions in order to achieve its favorable outcome. In particular, inany country a trade union always wants the government to attract the multinational,whilst a firm not. Hence, a trade union always wants to increase its payment to thegovernment if there is still space to gain in the case where the government wins themultinational, whilst a firm always wants to increase its payment to the governmentin the case where there is still space to gain if the government loses the competition.Therefore the (endogenously determined) best offer that a country could make tothe multinational is determined when both of the two interest groups could not gainirrespective of the outcome of the competition for the multinational. Next, if thebest offer of country i plus the profit that the multinational could earn in country iis greater than the best offer of country j plus the profit the multinational could earnin country j, then country j could never win the competition for the multinational.
We characterize the equilibria, which support what country i wins the competitionfor the multinational as the equilibrium outcome as follows.
Given(1
32+ 1
36
)(∆i −∆j) ≥
1
144
(1−aj
aj
)∆j −
1
144
(1−ai
ai
)∆i, first let us consider
the subcase where(1
32+1
36
)(∆i −∆j) ≥
5
144
(1− ai
ai
)∆i +
1
24
(1− aj
aj
)∆j.
Proposition 1 CTi = 0; CFj = 0; plus the following contribution schedules
CFi =
{0 if FDI in country i,
CFij if FDI in country j,
where CFij ∈[0, 5
144∆i];
CTj =
{0 if FDI in country i,
CTjj if FDI in country j,
16
where CTjj ∈[0, 1
24∆j]; constitute an equilibrium in the first stage of the game.
Proof. See Appendix.In equilibrium, country i wins the competition for the multinational, and pays the
amount,(1−aj
aj
)CTjj+
1
32∆j−
1
36(∆i −∆j), to the multinational. In the following dis-
cussions, we focus on the case where every interest group chooses a zero contributionschedule, and country i pays the amount, 1
32∆j −
1
36(∆i −∆j), to the multinational.
It is easy to see that the greater the ∆j is, the greater this amount is; the greaterthe ∆i is, the smaller this amount is. (Of course, ∆i and ∆j are the functions of thefundamental parameters, i.e., market scale, the slope of the inverse market demand,marketing cost, and unit production cost, of the model respectively.)
Indeed, in this subcase, choosing zero contribution schedule is a dominant strategyfor trade union i, and choosing zero contribution schedule is a dominant strategy forfirm j. In addition, given that there is no chance for country j to win the competitionfor the multinational, firm i can choose arbitrarily its contribution when its favorableoutcome occurs, and trade union j can choose arbitrarily its contribution when itsfavorable outcome occurs.
A more interesting subcase is the subcase where
1
144
(1− aj
aj
)∆j −
1
144
(1− ai
ai
)∆i
≤(1
32+1
36
)(∆i −∆j)
<
5
144
(1− ai
ai
)∆i +
1
24
(1− aj
aj
)∆j.
Proposition 2 The following contribution schedules
CTi =
{CTii if FDI in country i,
0 if FDI in country j,
where CTii ∈[0, 1
24∆i];
CFi =
{0 if FDI in country i,5
144∆i if FDI in country j;
CTj =
{0 if FDI in country i,
1
24∆j if FDI in country j;
CFj =
{CFji if FDI in country i,
0 if FDI in country j,
17
where CFji ∈[0, 5
144∆j
]; constitute an equilibrium in the first stage of the game, where
CTii , and CFji satisfy
(1− ai
ai
)(CTii −
5
144∆i
)+1
32∆i+
1
36(∆i −∆j) =
(1− aj
aj
)(1
24∆j − C
Fji
)+1
32∆j.
Proof. See Appendix.Indeed, the nature of the equilibria is a public good one. Please refer to Figure 2.
F
jiC
(5/144) ∆j
A
C
B
D
0 (1/24)∆i T
iiC
Figure 2: The public-good nature of the equilibria
The bold line represents the linear equation(1− ai
ai
)(CTii −
5
144∆i
)+1
32∆i+
1
36(∆i −∆j) =
(1− aj
aj
)(1
24∆j − C
Fji
)+1
32∆j.
The line segment AB denotes the equilibrium combination of CTii , and CFji .
From Figure 2, it is easy to show that this type of equilibria is unique. Supposethat either firm i contributes CFij <
5
144∆i, or trade union j contributes CTjj <
1
24∆j.
Then the bold line moves inward, say, represented by the dotted line. Now, theline segment CD denotes the equilibrium combination of CTii , and CFji . However,consider that either firm i contributes CFij + ε <
5
144∆i, or trade union j contributes
CTjj + ε <1
24∆j, ε > 0, ε → 0. Then country i would lose the competition for the
multinational. Hence, this is not an equilibrium.In equilibrium, country i wins the competition for the multinational, and since
there is a continuum of equilibria, the payment to the multinational cannot be de-termined. However, we want to know what the minimum payment is. It is easy to
18
show that the minimum payment is given by 1
144
(1−aj
aj
)∆j +
1
32∆j −
1
36(∆i −∆j).
Again, it is easy to see that the greater the ∆j is, the greater this payment is; thegreater the ∆i is, the smaller this payment is. Moreover, politics does matter here.The greater the aj is, the smaller this payment to the multinational is.
Lemma 2 Country j always wins the competition for the multinational, if and only
if Si +∆πM < Sj at CTii =
1
24∆i, C
Fij =
5
144∆i, C
Tjj =
1
24∆j, C
Fji =
5
144∆j, i.e.,
(1
32+1
36
)(∆i −∆j) <
1
144
(1− aj
aj
)∆j −
1
144
(1− ai
ai
)∆i.
Proof. See Appendix.What is the story behind Lemma 2? It is very much similar to that behind Lemma
1. However, here the best offer of country j plus the profit that the multinationalcould earn in country j is greater than the best offer of country i plus the profit themultinational could earn in country i, hence country i could never win the competitionfor the multinational.
We characterize the equilibria, which support what country j wins the competitionfor the multinational as the equilibrium outcome, in the following Proposition.
Proposition 3 The following contribution schedules
CTi =
{1
24∆i if FDI in country i,
0 if FDI in country j;
CFi =
{0 if FDI in country i,
CFij if FDI in country j,
where CFij ∈[0, 5
144∆i];
CTj =
{0 if FDI in country i,
CTjj if FDI in country j,
where CTjj ∈[0, 1
24∆j];
CFj =
{5
144∆j if FDI in country i,
0 if FDI in country j;
constitute an equilibrium in the first stage of the game, where CFij , and CTjj satisfy
(1− ai
ai
)(1
24∆i − C
Fij
)+1
32∆i+
1
36(∆i −∆j) =
(1− aj
aj
)(CTjj −
5
144∆j
)+1
32∆j.
19
Proof. See Appendix.Again, the nature of the equilibria is a public good one, and this type of equilibria
is unique.In equilibrium, country j wins the competition for the multinational, and since
there is a continuum of equilibria, the payment to the multinational cannot be de-termined. However, we want to know what the minimum payment is. It is easy to
show that the minimum payment is given by 1
144
(1−ai
ai
)∆i+
1
32∆i+
1
36(∆i −∆j). It
is easy to see that the greater the ∆j is, the smaller this payment is; the greater the∆i is, the greater this payment is. Moreover, politics does matter here. The greaterthe ai is, the smaller this payment is.
Notice that Proposition 3 implies a remarkable result. Though country i willgain more from the foreign direct investment than country j, and though the multi-national wants to locate in country i without subsidy competition between the twogovernments, the multinational will be attracted to country j if government j is suchcorrupted that can give the multinational a sufficiently big offer. Hence, the allocationefficiency of foreign direct investment is not realized.
4.2 The case where ai = 1, aj = 1
In this case we have
Si =1
32∆i,
Sj =1
32∆j.
Hence, we go back to the industrial organization oriented analysis. In particular,country i will always win the competition and offer the multinational a subsidy,which is equal to 1
32∆j −
1
36(∆i −∆j).
In the first stage of the game, for example, zero-contribution schedules constitutean equilibrium because the best offer of each of the two countries is constant, i.e.,politics does not matter in this case. Formally, we can establish the following result.
Proposition 4 CTi = 0; CFj = 0; plus the following contribution schedules
CFi =
{0 if FDI in country i,
CFij if FDI in country j,
where CFij ∈[0, 5
144∆i];
CTj =
{0 if FDI in country i,
CTjj if FDI in country j,
where CTjj ∈[0, 1
24∆j]; constitute an equilibrium in the first stage of the game.
20
Proof. See Appendix.It seems that Proposition 4 is similar to Proposition 1. However, the driving
forces behind Proposition 4 is different from those behind Proposition 1. Proposition4 says that since both of the two governments are benevolent, their objectives couldnot be influenced by special interest politics, whilst Proposition 1 says that when theparameters fall into the relevant region, either firm i or trade union j cannot changethe equilibrium outcome of the game by unilateral deviation.
5 Some Comparative Statics
In this section, we do some simple comparative statics. First we consider the politicalparameter, ai, then introducing the policy of minimum wage rate into our model.
5.1 Politics
In this subsection, we study the effect of the political parameter, ai, on the competi-tion for the multinational. The research questions are as follows.
First, in the case where 0 < ai < 1, 0 < aj < 1, i.e., both of the two govern-ments prefer tainted money to net social welfare, is it true that the more corrupteda government is, the more likely it would win the competition for the multinational?
Second, in the case where ai = 1, 0 < aj < 1, i.e., government i is benevolent,whilst government j is corrupted, whether can we find a critical value of aj, suchthat country j would win the competition for the multinational if aj < aj. (I.e., thedegree of corruption is increased.)12
5.1.1 The two corrupted governments
In this subsubsection, we assume ∆i = ∆j = ∆, therefore
∆πM =1
36(∆i −∆j) = 0.
Notice that in this case the best offers of the two countries are as follows.
Si =
(1− ai
ai
)(CTii − C
Fij
)+1
32∆,
Sj =
(1− aj
aj
)(CTjj − C
Fji
)+1
32∆.
12Notice that if government i is corrupted, whilst government is benevolent, then country j willalways lose the competition for the multinational.
21
Since ∆πM = 0, the country with the highest best offer will win the competition forthe multinational, and pays the amount, which is equal to the other country’s bestoffer, to the multinational.13
Now we cannot have in equilibrium that each of the four special interest groupschooses a zero-contribution schedule respectively. Why is that? Consider trade unionj contributes ε > 0, ε → 0. This will make country j win the competition for themultinational, and benefit trade union j. (By the same token, if firm i contributesε > 0, ε→ 0, this will make country i lose the competition for the multinational, andbenefit firm i.)
Proposition 5 If both government i, and government j are corrupted, and ∆i =∆j = ∆, then country i would win the competition for the multinational, if and only
if ai ≤ aj.
Proof. See Appendix.Therefore, if both of the two governments prefer tainted money to the net social
welfare, it is true that the more corrupted a government is, the more likely it wouldwin the competition for the multinational.
5.1.2 A corrupted government and a benevolent government
Notice that the best offers of the two countries are as follows.
Si =1
32∆i,
Sj =
(1− aj
aj
)(CTjj − C
Fji
)+1
32∆j.
Proposition 6 If government i is benevolent, whilst government j is corrupted, there
exists a critical value, aj,
aj =1
1 + 17
2
(∆i
∆j− 1) ,
such that country j will win the competition for the multinational if and only if aj <
aj.
Proof. See Appendix.Recall that Proposition 3 implies that though country i will gain more from the
foreign direct investment than country j, and though the multinational wants tolocate in country i without politics, the multinational will be attracted to countryj if government j is such corrupted that can give the multinational a sufficientlybig offer. Now Proposition 6 provides a concrete example: country j will win thecompetition for the multinational if aj < aj.
13If these two offers are the same, without loss of generality we assume that the multinationalchooses to locate in country i.
22
5.2 Minimum wage rate
In the previous analysis, we suppose that the wage rate in each country is equal tothe competitive wage rate, i.e., the marginal product of labor, wci =
1
γi. However, in
reality, the policy of minimum wage rate prevails. In this subsection, we introducethis policy into our model and consider its effect.
Let the minimum wage rate in country i be wi, which is assumed to be strictlygreater than wci . Now in the case where the multinational chooses to locate in countryi, we can show
qii = qMi =
αi −mii − γiwi6βi
,
Lii = LMi = γi
(αi −m
ii − γiwi6βi
),
πii = πMi =
(αi −mii − γiwi)
2
36βi,
ωii =(αi −m
ii − γiwi)
2
6βi,
csii =(αi −m
ii − γiwi)
2
18βi.
In the case where the multinational chooses to locate in country j, we can show
qij =αi −m
ii − γiwi4βi
,
Lij = γi
(αi −m
ii − γiwi4βi
),
πij =(αi −m
ii − γiwi)
2
16βi,
ωij =(αi −m
ii − γiwi)
2
8βi,
csij =(αi −m
ii − γiwi)
2
32βi.
We summarize the results in Table 3.Define
∆′
i =(αi −m
ii − γiwi)
2
βi, ∆′j =
(αj −m
jj − γjwj
)2
βj.
Notice that∆′i < ∆i, ∆
′
j < ∆j,
23
Term FDI NO WELFARE CHANGE
consumers’ surplus(αi−mi
i−γiwi)
2
18βi
(αi−mii−γiwi)
2
32βi
7(αi−mii−γiwi)
2
288βi
employment gains(αi−mi
i−γiwi)
2
6βi
(αi−mii−γiwi)
2
8βi
(αi−mii−γiwi)
2
24βi
domestic profits(αi−mi
i−γiwi)2
36βi
(αi−mii−γiwi)
2
16βi−5(αi−mi
i−γiwi)2
144βi
social welfare(αi−mi
i−γiwi)2
4βi
7(αi−mii−γiwi)
2
32βi
(αi−mii−γiwi)
2
32βi
Table 3: The redistribution effect of FDI under the policy of minimum wage rate
since wi >1
γi, and wj >
1
γj. Without loss of generality, we make the following
Assumption.
Assumption 2
∆′i > ∆′
j.
Therefore, the analysis in this case is much similar as the previous analysis.
Proposition 7 If ai = aj, αi = αj, βi = βj, mii = m
jj, and γi = γj, then country i
win the competition for the multinational if and only if wi ≤ wj.
Proof. See Appendix.Therefore, other things being equal, the country with the lowest minimum wage
rate will win the competition for the multinational.
6 Welfare Analysis
In this section, we consider the welfare effects. Our benchmark is the case whereai = 1, and aj = 1, i.e., the two governments are benevolent. In this case it should benoted that in equilibrium country i always wins the competition for the multinational,and pays the amount, 1
32∆j−
1
36(∆i −∆j), to the multinational; and a Pareto welfare-
worsening subsidy competition in a strong sense cannot happen because country j’ssocial welfare under subsidy competition is the same as that under no intervention.
What are the welfare effects when two corrupted governments engage in the com-petition for the multinational? We have the following Proposition.
Proposition 8 Consider the case where both government i and government j are
corrupted. First in the subcase where
(1
32+1
36
)(∆i −∆j) ≥
5
144
(1− ai
ai
)∆i +
1
24
(1− aj
aj
)∆j,
24
country i gets the same social welfare as that in the benchmark case, and country j
gets the same social welfare as that in the benchmark case. Second, in the subcase
where
5
144
(1− ai
ai
)∆i +
1
24
(1− aj
aj
)∆j >
(1
32+1
36
)(∆i −∆j)
≥1
144
(1− aj
aj
)∆j −
1
144
(1− ai
ai
)∆i,
a Pareto welfare-worsening subsidy competition in a weak sense occurs. Third, in the
subcase where
1
144
(1− aj
aj
)∆j −
1
144
(1− ai
ai
)∆i >
(1
32+1
36
)(∆i −∆j) .
a Pareto welfare-worsening subsidy competition in a strong sense occurs.
Proof. See Appendix.Notice that the third part of Proposition 8 points out the possibility that we may
observe a “Prisoner’s Dilemma” in a strong sense in the case where two corruptedgovernments compete for a multinational. The third part of Proposition 8 is true if
and only if 1
144
(1−aj
aj
)∆j −
1
144
(1−ai
ai
)∆i >
(1
32+ 1
36
)(∆i −∆j). However, according
to Lemma 2, this condition holds if and only if country j always wins the competitionfor the multinational. In other words, given that two corrupted governments competefor the multinational, a Pareto welfare-worsening subsidy competition for foreigndirect investment in a strong sense occurs when the country, which gains less from theforeign direct investment than the other country, and in which the multinational doesnot want to locate, is the winner country of the competition for the multinational.14
7 Discussions
In this section we compare the results derived and approach used in this paper withthose in the received literatures.
First we relate this paper to political economy models of competition for foreigndirect investment.
To the best of our knowledge, Haaparanta (1996) is the first paper, which usescommon agency framework to study competition for foreign direct investment and
14It is easy to show that if government i is corrupted, whilst government j is benevolent, countryi always wins the competition for the multinational, and the payment to the multinational is givenby 1
32∆j −
1
36(∆i −∆j), and the social welfare achieved is given by 1
4∆i −
[1
32∆j −
1
36(∆i −∆j)
],
which is the same as that in the benchmark case. Country j’s social welfare is given by 7
32∆j , which
is equal to that in the benchmark case.We omit the welfare analysis of the case where government i is benevolent, whilst government j
is corrupted. Indeed, the analysis is much similar as the analysis we do in the text.
25
shows that a country in which “competitiveness” in terms of production costs deterio-rates (e.g., a high wage country,) may be able to attract investment in the equilibriumof the game. In this paper, we show a result in the same spirit that a less competitivecountry may win the competition for the multinational. (See Result 1.) Therefore, anatural question is that whether Haaparanta (1996) already implies our result. Theanswer is a NO. We show this by investigating the implications of Haaparanta’s modelin the context of this paper: competing for one unit indivisible investment, there isno trade between the two countries, and the policy instrument used is a lump-sumsubsidy. We use Haaparanta’s notations, please refer to Haaparanta (1996), pp. 145.
Without loss of generality, we assume wi < wj. Now, if the multinational investsin country i, it maximizes
πi = Ri (F (K,Li) ,Mi)− wiLi + si − rK.
SupposeMi =Mj. Then it is easy to show thatRi > Rj.15 Hence, if the two countriesdo not engage in the subsidy competition, the multinational would invest in countryi. Subsidy competition could not change this but transfer surplus from country i tothe multinational. Why is that? The best offer of country j to the multinational issj = wjLj. So, if the multinational invests in country j, it gets Rj − rK given thisoffer. If the multinational invests in country i, it gets Ri−wiLi+ si−rK. By settingsi = wiLi − (Ri −Rj), country i always wins the competition for the multinational.
We could draw a conclusion that Haaparanta’s result is not robust to the limitcase where a multinational invests all of its money in one of the two countries. In thiscase, a country in which “competitiveness” in terms of production costs deteriorates(e.g., a high wage country,) could never attract investment in the equilibrium of thegame. However, this could happen in our model, and the driving forces are politicaldistortions and special interest politics.
Using a model addressing the question of politician’s decision making with re-election concerns, Biglaiser and Mezzetti (1997) derive a similar result as ours: theallocation of foreign direct investment may be inefficient.16
How do we explain this similarity? We argue that there are different driving forcesbehind the similar results. In their paper, the driving forces are political distortion,which is represented by the degree of how benevolent an elected official is, and amedian voter’s incumbency bias, whilst in our model the driving forces are politicaldistortions and special interest politics. In this paper, political distortions work
15The first order condition for profit maximization is as follows:
RiQFL = wi.
SinceMi =Mj , RiQ = RjQ. Because FLL < 0, we must have Li > Lj given wi < wj . Since FL > 0,Qi > Qj . Because R′iQ > 0, Ri > Rj .
16In their paper, social welfare is defined as a median voter’s utility.
26
through the channel of a common agency, whilst in their paper, political distortionswork through the channel of an incumbency bias.17
It should be noted that this research and Biglaiser and Mezzetti (1997) are com-plements rather than substitutes. All of the two researches show the negative effectsof political distortions on competition for foreign direct investment, i.e., the allocationof foreign direct investment may be inefficient.
Second, we relate this paper to industrial organization models of competition forforeign direct investment, which consider competition for foreign direct investmentunder imperfect competition without political distortions. (See Appendix B for de-tails.) The main results of this branch of research are as follows.
On the positive side, the allocation efficiency of foreign direct investment is alwaysrealized.18
On the normative side, the competition could not be a “Prisoner’s Dilemma” ina strong sense.
However, we show that all of these could be changed if political distortions exist.
Third, it should be noted that in this paper we use a common agency framework toanalyze competition for foreign direct investment. However, we use Subgame PerfectNash Equilibrium rather than Truthful Equilibrium as a solution concept. Why isthat? Recall that in country i, firm i’s contribution schedule is given by
CFi =
{CFii if FDI in country i,CFij if FDI in country j;
whilst trade union i’s contribution schedule is given by
CTi =
{CTii if FDI in country i,CTij if FDI in country j.
17There is a difference between these two researches: in this paper, it is easy to show that inequilibrium a government’s valuation for a multinational is always greater than or equal to the netsocial welfare it would create, whilst in their paper, a government’s valuation for a multinationalmay be strictly smaller than the net social welfare it would create. (A government’s valuation for amultinational may be greater than or equal to the net social welfare it would create as well in ourmodel.)Again the above driving forces matter. In their paper, if the expected incumbency is positive,
an elected official would have less incentive to attract the investment, whilst in this paper, since agovernment likes tainted money, and a trade union, which welcomes the multinational, always winsthe lobby campaign, hence, a government always wants to pay more than the amounts of net socialwelfare to the multinational. (Of course, if a firm wins the lobby campaign, then a governmentwants to pay less than the amounts of net social welfare to the multinational. However, this is notan equilibrium outcome in this paper.)
18A government’s valuation for the multinational could not be greater than the net social welfareit would create. The intuition is quite simple. Since there is no political distortions, the governmentmaximizes social welfare.
27
I.e., contribution schedules are contingent on the outcome of competition for themultinational rather than what action government i would take, which is the caseconsidered by Bernheim and Whinston (1986) where Truthful Equilibrium is usedas a solution concept. In the case where contribution schedules are contingent onthe outcome, how we develop a “truthful equilibrium”, which is the counterpart ofTruthful Equilibrium in Bernheim and Whinston (1986), is an interesting researchquestion.
8 Conclusion
In this paper, we introduce domestic politics into the analysis of competition forforeign direct investment by two national governments. A government is concernedwith both social welfare and campaign contributions from special interest groups. Weshow that though one country will gain more from the foreign direct investment thanthe other country, and the multinational wants to locate in the former country, themultinational will be attracted to the latter country if the latter country’s government,which is driven by its domestic politics, can give the multinational a sufficiently bigoffer. This implies that the allocation efficiency may not be achieved. Given thattwo domestic politics driven governments compete for the multinational. A Paretowelfare-worsening subsidy competition for foreign direct investment in a strong senseoccurs when the country, which gains less from the foreign direct investment thanthe other country, and in which the multinational does not want to locate, wins thecompetition for the multinational.
Besides the contributions to the existing literatures of competition for foreigndirect investment, this research has significant policy implications. Recently, JoséManuel Barroso, the new president of the European Commission, assailed Frenchand German efforts to end tax competition among European Union countries.
“Some member countries would like to use tax harmonization to raisetaxes in other countries to the high-tax levels in their own countries,” Mr.Barroso said in an interview during the World Economic Forum’s annualmeeting in this Swiss ski resort. “We do not accept that. And memberstates will not accept it.”19
His view has been supported by some economists. For example, Milton Friedmansaid that
Competition, not identity, among countries in government taxationand spending is highly desirable. How can competition be good in the
19Wall Street Journal Europe, 31 January 2005.
28
provision of private goods and services but bad in the provision of gov-ernmental goods and services? A governmental tax and spending cartelis as objectionable as a private cartel.20
However, this paper implies that if the countries, which engage in the compe-tition for foreign direct investment, have domestic politics driven governments andentrenched interest groups, then we would expect that this competition might be a“Prisoner’s Dilemma”, either in a weak sense or in a strong sense.
One may argue that in this paper we just consider the simplest case where there isno trade between different countries. However, we wonder whether the basic resultsderived from the simplest case could be changed when considering more complicatedcases. The key point is that since foreign direct investment has income redistributioneffects, different special interest groups do have incentive to lobby the governmentto attract, or not to attract the multinational, i.e., to shape the government’s ob-jective. Considering more complicated cases is equivalent to considering differentredistributions due to foreign direct investment. The key point cannot be changed.
Also in this paper, we use Subgame Perfect Nash Equilibrium rather than Truth-ful Equilibrium as a solution concept because special interest groups’ contributionschedules are contingent on the outcome of competition for the multinational ratherthan what action a government would take, which is the case considered by Bernheimand Whinston (1986) where Truthful Equilibrium is used as a solution concept. Inthe case that this paper considers, how we develop a “truthful equilibrium”, whichis the counterpart of Truthful Equilibrium in Bernheim and Whinston (1986), is aninteresting research question.
We wonder whether this paper can provide explanation to the case where UK andFrance compete for Hoover, an American company.21 It is documented that France,the loser of this competition, accuses UK, the winner of this competition, of erodingworkers’ rights by restricting their right to go on strike. Therefore, it seems thatworkers do lose something in this case, which is not captured by our research. Howwe provide appropriate explanation to this case is another interesting research topic.
References
[1] Barros, P. P. and Cabral, L. (2000). “Competing for foreign direct investment”,Review of International Economics, vol. 8, pp. 360-371.
[2] Bernheim, B. D. and Whinston, D. W. (1986). “Menu auctions, resource allo-cation, and economic influence”, Quarterly Journal of Economics, vol. 101, pp.1-31.
20See Barros and Cabral (2000).21See Haaparanta (1996), and Barros and Cabral (2000).
29
[3] Biglaiser, G. and Mezzetti, C. (1997). “Politicians’ decision making with re-election concerns”, Journal of Public Economics, vol. 66, pp. 425-427.
[4] Facchini, G. (2004). “The political economy of international trade and factormobility”, Journal of Economic Surveys, vol. 18, pp. 1-31.
[5] Facchini, G. and Willmann, G. (Forthcoming). “The political economy of inter-national factor mobility”, Journal of International Economics.
[6] Fumagalli, C. (2003). “On the welfare effects of competition for foreign directinvestments”, European Economic Review, vol. 47, pp. 963-983.
[7] Grossman, G. M. and Helpman, E. (1994). “Protection for sale”, American Eco-
nomic Review, vol. 84, pp. 833-850.
[8] Grossman, G. M. and Helpman E. (1995a). “The politics of Free-trade agree-ments”, American Economic Review, vol. 85, pp. 667-690.
[9] Grossman, G. M. and Helpman E. (1995b). “Trade wars and trade talks”, Journal
of Political Economy, vol. 103, pp. 675-708.
[10] Grossman, G. M. and Helpman E. (2001). Special Interest Politics. Cambridge,MA: The MIT Press.
[11] Haaparanta, P. (1996). “Competition for foreign direct investments”, Journal of
Public Economics, vol. 63, pp. 141-153.
[12] Haufler, A. and Wooton, I. (1999). “Country size and tax competition for foreigndirect investment”, Journal of Public Economics, vol. 71, pp. 121-139.
[13] Helpman, E. (1997). “Politics and trade policy”, in (D. M. Kreps and K. F. Wal-lis, eds.) Advances in Economics and Econometrics: Theory and Applications,vol. 1, Cambridge: Cambridge University Press, pp. 19-45.
[14] Kayalica, M. Ö. and Lahiri, S. (2003). “Domestic lobbying and foreign directinvestment: The role of policy instruments”, mimeo.
[15] Lahiri, S. and Raimondos-Møller, P. (2000). “Lobbying by ethnic groups and aidallocation”, Economic Journal, vol. 110, pp. 62-79.
[16] Lahiri, S. and Ono, Y. (2004). Trade and Industrial Policy under International
Oligopoly. Cambridge: Cambridge University Press.
[17] Oman, C. (2000). Policy Competition for Foreign Direct Investment. Paris:OECD.
[18] Persson, T. and Tabellini, G. (2000). Political Economics: Explaining Economic
Policy. Cambridge, MA: The MIT Press.
30
[19] Putnam, R. D. (1988). “Diplomacy and domestic politics: The logic of two-levelgames”, International Organization, vol. 42, pp. 427-460.
[20] UNCTAD. (1996). Incentives and Foreign Direct Investment. New York: UnitedNations.
[21] Venables, A. J. and Navaretti, G. B., with F. Barry, K. Ekholm, A. Falzoni, J.Haaland, K.-H. Midelfart and A. Turrini. (Forthcoming). Multinational Firms
in the World Economy. Princeton: Princeton University Press.
[22] Wilson, J. D. (1999). “Theories of tax competition”, National Tax Journal, vol.52, pp. 269-304.
Appendix A: Technical Proofs
Proof of Lemma 1
(Sufficiency part.) Suppose that the condition holds, however, country j wins thecompetition for the multinational. Hence, we must have Si + 1
36(∆i −∆j) < Sj, at
(CTii CFij CTjj CFji
)′
�=(
1
24∆i
5
144∆i
1
24∆j
5
144∆j
)′
,
and country j pays the amount, bj = Si +1
36(∆i −∆j), to the multinational.
Step 1. Suppose CTii �=1
24∆i, i.e., CTii <
1
24∆i. Then trade union i, taking the
equilibrium outcome of the subsequent competition for the multinational into account,can choose to contribute CTii + ε <
1
24∆i, ε > 0, ε→ 0. Since Si increases with trade
union i’s political contributions, now bj < Si + 1
36(∆i −∆j), i.e., country i wins the
competition for the multinational. Notice that trade union i does have incentive toincrease its political contributions: it gets 1
8∆i in the case where country j wins the
competition for the multinational, whilst it gets 1
8∆i +
(1
24∆i − C
Tii − ε
)> 1
8∆i in
the case where country i wins the competition for the multinational. Therefore, ifin equilibrium, country j wins the competition for the multinational, we must haveCTii =
1
24∆i.
Step 2. Given CTii =1
24∆i. Then firm j, taking the equilibrium outcome of the
subsequent competition for the multinational into account, can choose to contributeCFji =
5
144∆j. If the condition holds, this guarantees that country i wins the competi-
tion for the multinational. Does firm j have incentive to do this? Notice that it gets1
36∆j whatever the winner country is.Therefore, we cannot find an equilibrium, which supports what country j wins
the competition for the multinational, if the condition holds.(Necessity part.) Suppose that the condition does not hold, i.e., Si+∆πM < Sj at
CTii =1
24∆i, CFij =
5
144∆i, CTjj =
1
24∆j, CFji =
5
144∆j. We show that country i cannot
31
win the competition for the multinational. Let us assume that country i wins thecompetition for the multinational. Hence, we must have Si + 1
36(∆i −∆j) ≥ Sj, at
(CTii CFij CTjj CFji
)′
�=(
1
24∆i
5
144∆i
1
24∆j
5
144∆j
)′
,
and country i pays the amount, bi = Sj − 1
36(∆i −∆j), to the multinational.
Step 1. Suppose CTjj �=1
24∆j, i.e., CTjj <
1
24∆j. Then trade union j, taking the
equilibrium outcome of the subsequent competition for the multinational into account,can choose to contribute CTjj + ε <
1
24∆j, ε > 0, ε→ 0. Since Sj increases with trade
union j’s political contributions, now bi < Sj − 1
36(∆i −∆j), i.e., country j wins the
competition for the multinational. Notice that trade union j does have incentive toincrease its political contributions: it gets 1
8∆j in the case where country i wins the
competition for the multinational, whilst it gets 1
8∆j +
(1
24∆j − C
Tjj − ε
)> 1
8∆j in
the case where country j wins the competition for the multinational. Therefore, ifin equilibrium, country i wins the competition for the multinational, we must haveCTjj =
1
24∆j.
Step 2. Given CTjj =1
24∆j. Then firm i, taking the equilibrium outcome of the
subsequent competition for the multinational into account, can choose to contributeCFij =
5
144∆i. If the hypothesis holds, this guarantees that country j wins the com-
petition for the multinational. Does firm i have incentive to do this? Notice that itgets 1
36∆i whatever the winner country is.
Therefore, we cannot find an equilibrium, which supports what country i wins thecompetition for the multinational, if the hypothesis holds. �
Proof of Proposition 1
This Proposition shows that there is a continuum of equilibria in the case that we areconsidering. Hence, we need to check whether there is any player who has unilateralincentive to deviate from any equilibrium. Notice that since in this continuum ofequilibria, country i wins the competition for the multinational, both trade union iand firm j do not have inventive to deviate in any equilibrium. (Indeed, choosingzero contribution schedule is a dominant strategy for trade union i, and choosing zerocontribution schedule is a dominant strategy for firm j.) Moreover, since
(1
32+1
36
)(∆i −∆j) ≥
(1− ai
ai
)5
144∆i +
1
24
(1− aj
aj
)∆j,
it is easy to show that given any equilibrium, either firm i, or trade union j cannotmake unilateral deviation, and make country j win the competition for the multina-tional. �
Proof of Proposition 2
Given the contribution schedules country i wins the competition for the multinational.Given that is there any player who has incentive to unilaterally deviate from the
32
proposed strategy profile? First, notice that both firm i and trade union j do not haveincentive to deviate from the strategy profile because contributing less cannot changethe equilibrium outcome of the subsequent game. Next, if firm j contributes less thanthe proposed amount (if possible,) then country j wins the competition. Firm j gets1
36∆j, which is smaller than or equal to its payoffs if the proposed strategy profile
is implemented. Finally, as for trade union i, contributing more than the proposedamount (if possible,) will decrease trade union i’s payoffs. If it contributes less thanthe proposed amount (if possible,) country j would win the competition. It gets1
8∆i, which is smaller than or equal to its payoffs if the proposed strategy profile is
implemented. A continuum of Nash equilibria is established. �
Proof of Lemma 2
Notice that Lemma 2 is the mirror of Lemma 1. The necessity part of the proof ofLemma 1 is the sufficiency part of the proof of Lemma 2. The sufficiency part of theproof of Lemma 1 is the necessity part of the proof of Lemma 2. �
Proof of Proposition 3
Given the contribution schedules country j wins the competition for the multinational.Given that is there any player who has incentive to unilaterally deviate from theproposed strategy profile? First, notice that both firm j and trade union i do not haveincentive to deviate from the strategy profile because contributing less cannot changethe equilibrium outcome of the subsequent game. Next, if firm i contributes less thanthe proposed amount (if possible,) then country i wins the competition. Firm i gets1
36∆i, which is smaller than or equal to its payoffs if the proposed strategy profile
is implemented. Finally, as for trade union j, contributing more than the proposedamount (if possible,) will decrease trade union j’s payoffs. If it contributes less thanthe proposed amount (if possible,) country i would win the competition. It gets1
8∆j, which is smaller than or equal to its payoffs if the proposed strategy profile is
implemented. A continuum of Nash equilibria is established. �
Proof of Proposition 4
Since in this case, country i will always win the competition for the multinational,both trade union i and firm j do not have incentive to contribute positive amounts,whilst both firm i and trade union j can choose to contribute any feasible amounts.�
33
Proof of Proposition 5
According to Lemma 1, we know that country i will win the competition for themultinational, if and only if Si ≥ Sj at CTii = C
Tjj =
1
24∆, CFij = C
Fji =
5
144∆, i.e.,
1
144
(1− ai
ai
)∆+
1
32∆ ≥
1
144
(1− aj
aj
)∆+
1
32∆
⇔1− ai
ai≥
1− aj
aj⇔
ai ≤ aj.
�
Proof of Proposition 6
According to Lemma 2, we know that country j will win the competition for themultinational, if and only if Si + 1
36(∆i −∆j) < Sj at CTjj =
1
24∆j, CFji =
5
144∆j, i.e.,
1
32∆i +
1
36(∆i −∆j) <
1
144
(1− aj
aj
)∆j +
1
32∆j
⇔
aj <1
1 + 17
2
(∆i
∆j− 1) .
Define
aj =1
1 + 17
2
(∆i
∆j− 1) .
Notice that 0 < aj < 1, therefore, aj is well defined. �
Proof of Proposition 7
Given αi = αj, βi = βj, mii = m
jj, and γi = γj. According to Lemma 1, we
know that country i will win the competition for the multinational, if and only if
34
Si +1
36
(∆′i −∆
′
j
)≥ Sj at CTii =
1
24∆′i, C
Fij =
5
144∆′i, C
Tjj =
1
24∆′j, C
Fji =
5
144∆′j, i.e.,
(1
32+1
36
)(∆′
i −∆′
j
)≥
1
144
(1− aj
aj
)∆′
j −1
144
(1− ai
ai
)∆′i
⇔(1
32+1
36
)(∆′i −∆
′
j
)+
1
144
(1− a
a
)(∆′i −∆
′
j
)≥ 0
⇔
∆′i −∆′
j ≥ 0
⇔
wi ≤ wj.
�
Proof of Proposition 8
The first part is implied by Lemma 1, and Proposition 1. In this case, countryi wins the competition, and the payment to the multinational is given by 1
32∆j −
1
36(∆i −∆j), and the social welfare achieved is given by 1
4∆i−
[1
32∆j −
1
36(∆i −∆j)
],
which is the same as that in the benchmark case. Country j’s social welfare is givenby 7
32∆j, which is equal to that in the benchmark case.
The second part is implied by Lemma 1, and Proposition 2. In this case, countryi wins the competition, and the minimum payment to the multinational is given
by 1
144
(1−aj
aj
)∆j +
1
32∆j −
1
36(∆i −∆j), and the social welfare achieved is given
by 1
4∆i −
[1
144
(1−aj
aj
)∆j +
1
32∆j −
1
36(∆i −∆j)
]. It is easy to show that the social
welfare achieved is smaller than that in the benchmark case, which is given by 1
4∆i−[
1
32∆j −
1
36(∆i −∆j)
]. Whilst country j’s social welfare is given by 7
32∆j, which is
equal to that in the benchmark case.The third part is implied by Lemma 2 Proposition 3. In this case, country j
wins the competition, and the minimum payment to the multinational is given by1
144
(1−ai
ai
)∆i+
1
32∆i+
1
36(∆i −∆j), and the social welfare achieved is given by 1
4∆j−[
1
144
(1−ai
ai
)∆i +
1
32∆i +
1
36(∆i −∆j)
]. It is easy to show that the social welfare
achieved is smaller than that in the benchmark case, which is given by 7
32∆j. Country
i’s social welfare is given by 7
32∆i, which is smaller than that in the benchmark case.
�
35
Appendix B: Summary of the Results Based on In-
dustrial Organization Approach
In Appendix B, we construct a simple model to summarize the results of industrial or-ganization based papers on competition for foreign direct investment, such as Hauflerand Wooton (1999), Barros and Cabral (2000), Fumagalli (2003), etc.
Suppose that the foreign firm would like to invest in one of the two countries: 1and 2. There is no domestic production.
Consider two regimes: I — no intervention; II — competition for foreign directinvestment.
Assume that without governments’ interventions, the multinational would like toinvest in country 1.
The two governments compete for the multinational, and the policy instrumentavailable is a lump-sum subsidy (tax).
If the multinational locates in country 1, the outcome is summarized as a three-tuple (
W F1 ,W
N2 ,Π1
),
where WF1
is country 1’s social welfare, WN2
is country 2’s social welfare, and Π1 isthe multinational’s profits. If the multinational locates in country 2, the outcome issummarized as a three-tuple (
WN1,W F
2,Π2
),
where WN1
is country 1’s social welfare, W F2
is country 2’s social welfare, and Π2 isthe multinational’s profits. We define
∆W1 = WF1 −W
N1 > 0,
∆W2 = WF2 −W
N2 > 0,
∆Π = Π1 − Π2 > 0.
(These three ∆s are functions of market size, trade cost, and the parameter of tech-nological transfer, etc.)
What are the equilibrium outcome and the welfare effects of this game?
Case 1 ∆Π > ∆W2. In equilibrium, country 1 always wins the competition for the
multinational, and can charge a tax on the multinational, which is equal to
T = ∆Π−∆W2.
Welfare effects: 1 is better-off, 2 is unchanged, and the total welfare of the two coun-
tries is increased.
36
Case 2 ∆Π < ∆W2, but ∆W1 +∆Π > ∆W2. In equilibrium, country 1 always wins
the competition for the multinational, and pays a subsidy to the multinational, which
is equal to
S = ∆W2 −∆Π.
Welfare effects: 1 is worse-off, 2 is unchanged, and the total welfare of the two coun-
tries is decreased.
Case 3 ∆Π < ∆W2, and ∆W1+∆Π < ∆W2. In equilibrium, country 2 always wins
the competition for the multinational, and pays a subsidy to the multinational, which
is equal to
S = ∆W1 +∆Π.
Welfare effects: 1 is worse-off, 2 is better-off, and the total welfare of the two countries
is indeterminate.
The above analysis implies that
• First, the allocation efficiency of foreign direct investment is always realized.22
• Second, there could not exist a Pareto welfare-worsening subsidy competitionin a strong sense.
(In the above cases, the reference regime is non-intervention when we do welfareanalysis. However, whether or not can we have Pareto-improving subsidy competitionin the strong sense? We cannot address this question in the above simple setting.However, if we have a regime III: direct export plus domestic production, then ifthis is the reference regime, all of the two countries may be better-off under thecompetition for FDI, which is shown by Fumagalli (2003).)
22Also notice that country i’s valuation for the multinational is ∆Wi, i = 1, 2.
37