Bidding for Firms with Unknown Characteristics

• Published date: 01 July 2019
• Author: Andrea Schneider,Johannes Becker
• DOI: http://doi.org/10.1111/sjoe.12309
• Date: 01 July 2019

Scand. J. of Economics 121(3), 1222–1243, 2019

DOI: 10.1111/sjoe.12309

Bidding for Firms with Unknown

Characteristics*

Johannes Becker

University of M¨unster, DE-48143 M¨unster, Germany

johannes.becker@wiwi.uni-muenster.de

Andrea Schneider

University of M¨unster, DE-48143 M¨unster, Germany

andrea.schneider@uni-muenster.de

Abstract

When a region successfully attracts a firm by offering subsidies, the firm often commits itself to

performance targets in terms of employment. In this paper,we interpret these firm-specific targets

as a consequence of incomplete information. We analyze a model of two regions that compete

for a firm, assuming that the firm’s productivity is ex ante unknown.We show that performance

targets often induce overemployment in high-productivity firms, and that tax credits are often

superior to lump-sum payments. Moreover, when regions differ in wage rates, the low-wage

region wins the bid and has a higher surplus than under complete information. Finally, weshow

that, under incomplete information, bidding might not lead to efficient firm location.

Keywords: Business taxation; incomplete information; mechanism design; state aids; subsidy

competition

JEL classification:F23; H25; H71

I. Introduction

The location of a firm in a given jurisdiction can substantially increase

its residents’ welfare (e.g., by increasing tax revenue or via technological

spillovers to domestic firms). It is therefore not surprising that municipal or

regional governments are willing to offer subsidies to attract firms. Instead

of lump-sum payments, these financial incentives often take the form of tax

credits associated with some specific performance commitment in terms of

investment, output, or – in most cases – employment. These firm-specific

contracts can be interpreted as a consequence of incomplete information:

*We thank Sebastian Krautheim, Gr´egoire Rota Graziosi, Marco Sahm, and participants at

conferences and seminars in Taormina, D¨usseldorf, M¨unchen, Mannheim, Bayreuth, and Oslo

for helpful comments. The project was partly developed whenA. Schneider was at Oslo Fiscal

Studies at the Department of Economics, University of Oslo, supported by the Research Council

of Norway.All remaining errors are our own.

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The editors of The Scandinavian Journal of Economics 2018.

J. Becker and A. Schneider 1223

an individual region is willing to bid for the firm according to the surplus

it creates, but the size of the surplus might a priori be unknown or, at least,

only imprecisely measurable. A tax credit elegantly conditions on the type

of the firm by making its value dependent on the firm’s future profits; and

by committing itself to an employment target, the firm can signal its type

and, thus, reduce the information asymmetry.

In this paper, we consider a model with two regions that engage in

a bidding competition for a firm with unknown characteristics. These

characteristics will ultimately determine the welfare gain from attracting the

firm. Welfare gains take the form of increased tax revenue and technological

spillovers to domestic firms. We consider direct non-linear mechanisms

that induce truthful reporting of the firm’s type under both symmetric

and asymmetric competition. Asymmetries are given due to differences in

workers’ outside option (which translate into different wage rates across

locations) and the size of the technological spillovers.

Our contribution is threefold. First, we add to the body of literature on

bidding for firms (Black and Hoyt, 1989) by applying a classical screening

model (Rothschild and Stiglitz, 1976) with two competing principals

(Biglaiser and Mezzetti, 1993) to it. We argue that this application is

useful and helps in the understanding of features of real-world contracts

between regions and firms that have, so far, been neglected in the literature

on bidding. In line with the literature on screening, we show that,

under symmetric competition, equilibrium contracts yield zero expected

regional payoffs and a full capture of the surplus by each firm type.

With asymmetric competition, the dominating region keeps some of the

surplus. Moreover, incomplete information provides a rationale for tax

credits instead of lump-sum payments and firm-specific employment targets

instead of free labor input choice – even if there is no risk that the firm

cashes in the subsidy and leaves (or just provides a hollow entity without

any productive activity in it). These employment targets are often used in

real-world contracts. In our framework, however, they sometimes imply

inefficient overemployment (the second-best distortion typical for screening

equilibria under asymmetric information).

Second, we contribute to the literature on screening by providing

an example of a case in which incomplete information can benefit

the uninformed side of the market. Specifically, under wage asymmetry,

the low-wage government can have a larger surplus under incomplete

information than in the equivalent equilibrium under complete information.

Although the framework is rather policy applied, we argue that this finding

will survive in more general settings. It applies to all asymmetric situations

in which the (dominated) competitor offers a contract in which employment

(or, more generally, effort) is distorted due to an incentive compatibility

constraint and the dominating principal can beat this offer with a bid

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The editors of The Scandinavian Journal of Economics 2018.