Should Governments Compete for Foreign Direct Investment?

Abstract

We study two governments, each considering whether or not to compete to attract a foreign monopoly firm into its own domestic market. The competition, should it occur, would involve offering incentives to the firm. The incentives, which are costly for the governments to provide, lower the firm s marginal cost of production. Faced with the offers from each country, the firm must choose one of four options: to enter either of the markets, produce there and export to the other, to enter both markets simultaneously with only local production, or to reject all offers. We find conditions under which it would be optimal for one of the two countries not to compete with the other, preferring instead to import the commodity from the country that attracted the firm, rather than incurring the additional costs that would have been necessary to make its own economy more attractive to the foreign firm. We show that when importing the good is a possibility, there are conditions under which, knowing that it will lose (win) the competition for the firm, the country nonetheless finds it optimal to (not) compete. Also, we derive the market structure by establishing the relationship between the option chosen by the firm and the characteristics of the two governments trying to attract the firm.