An optimal incentive contract to avert firm relocation

In a globalized economy, firms move production to other countries without turning a hair. A local policy maker who seeks to avert relocation faces a dynamic problem - incentivizing the firm to remain in its home country today does not guarantee that the firm also stays in the future. We investigate situations where contracts between a local regulator and the firm can be written on some contractible productive activity, e.g. labor, output, or the firm's emissions. The firm undertakes a location-specific investment that is not contractible. When long-term contracts are feasible, the regulator averts relocation by postponing a sufficient amount of transfer to the second period. With limited commitment, i.e. when only short-term contracts are feasible, contracts with positive transfers in the second period cannot be implemented if the firm's investment is unobservable to the regulator. The regulator can avoid this problem by a tighter regulation in the first period. This induces the firm to invest more, which creates a `lock-in effect' that prevents relocation without transfers in period 2. An important application of our model is in the area of climate policy, where firm relocation can be triggered via a unilateral introduction of an emissions price by a country.