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Interjurisdictional Competition with Adverse Selection
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.