Optimal incentive contracts to avert firm relocation

Martin Pollrich and Robert Schmidt

Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems from Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich

Abstract: A unilateral policy intervention by a country (such as the introduction of an emission price) can induce firms to relocate to other countries. We analyze a dynamic game where a regulator offers contracts to avert relocation of a firm in each of two periods. The firm can undertake a location-specific investment (e.g., in abatement capital). Contracts can be written on some contractible productive activity (e.g., emissions), but the firm's investment is not contractible. A moral hazard problem arises under short-term contracting that makes it impossible to implement outcomes with positive transfers in the second period. The regulator resorts to high-powered incentives in the first period. The firm then overinvests and a lock-in effect prevents relocation in both periods. Paradoxically, the distortion in the firstperiod contract can be so severe that higher transfers are needed to avert relocation compared to a (hypothetical) situation without the investment opportunity.

Keywords: moral hazard; contract theory; limited commitment; firm mobility; abatement capital (search for similar items in EconPapers)
JEL-codes: D82 D86 L51 Q58 (search for similar items in EconPapers)
Date: 2014-09-16
New Economics Papers: this item is included in nep-bec, nep-cta, nep-env, nep-hrm, nep-mic and nep-reg
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Working Paper: An optimal incentive contract to avert firm relocation (2014)
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