Competition for foreign direct investments

This paper models international competition for foreign direct investment as a common agency problem using the theory of menu auctions developed by Bernheim and Whinston. In the model, national governments act as principals and a multinational corporation as the single agent. Governments are assumed to maximize the net wage income generated by the corporation's investment. It is shown that in the equilibrium of this game a high wage country may be able to attract investment even though all countries use subsidies. Furthermore, it is shown that a country may choose to pay the highest subsidies even if it attracts less investment than in the unsubsidized regime. Our framework can also be used to study interregional subsidy competition within a country.