Competing for Public Goods and Private Business

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by

JOSHUA S. GANS
Melbourne Business School, University of Melbourne, 200 Leicester Street Carlton, Victoria, 3053, Australia. E-Mail: J.Gans@mbs.unimelb.edu.au.

First Draft: 20 November, 1995 This Version: 30 August, 1996

This paper provides a theoretical examination of the potential costs of interstate rivalry in acquiring major sporting/cultural events and large investment projects, the ownership rights to which are held be a sole supplier. In addition to greater acquisition costs, such competition can also result in distortions in the types of event held away from the social optimum and even the possibility that the state that values the event least could win. Nonetheless, the existence of political motivations generates the possibility that competition could be socially beneficial. Journal of Economic Literature Classification Numbers: D44, H77 Keywords: rents, bidding, auctions, interstate competition, major events.

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I am grateful to Maxim Engers and Robin Stonecash for helpful discussions. Responsibility for all views expressed remain my own.

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I. Introduction There have been many recent examples of state governments in Australia competing with one other to attract major events and private investment projects to their states. The Formula One, Indy Car and Motor Cycle Grand Prix, the Fox movie studios, and the Olympic games are but a few prominent instances of fierce interstate rivalry. While some commentators have debated the economic value of such events and whether they are actually worth competing over (see Mules, 1995 and the references therein), this paper takes a brief look at the distortions introduced by competitive bidding. To this end it is assumed that events under consideration are of positive economic value to competing states -- at least up to a point. The paper will focus on how interstate competition for these events changes their economic value. This paper models bidding for major events as a standard ascending bid auction with independent private values. Each state submits a bid to the event promoter with other states being given the opportunity to raise the bid in turn. The game stops when no state wishes to raise the bid on the table. The difference between this game and standard auction theory is that the strategy space is multi-dimensional -- consisting of a choice of the nature of the event to be held in addition to monetary compensation. It will be shown that this extra dimension can lead to the type of event that is part of the winning bid being distorted from that which would be socially preferred. Moreover, under similar conditions to those generating event distortions, it is possible that the “wrong” state could win the event. That is, the winning state may not be the state that values the event the most, but the one that faces less cost at the margin in providing an event more closely aligned with the promoter’s interests. Thus, there is a potential selection cost from competition. This paper characterises the conditions under which such costs arise. It should be emphasised that these are costs from a national point of view. If we include the

3 preferences of the event promoter the outcomes are Pareto optimal. As such, there is a prima facie case for some national regulation of interstate rivalry.1 Much of the analysis of the paper assumes that government decision-makers attempt to maximise the social value function of the state. However, it is possible that political motives could distort these incentives. When the possibility of political motivations entering into the competitive strategies of states is considered, somewhat paradoxically, interstate rivalry can be beneficial in reducing these costs. This occurs because competition can pressure politicians, who face private costs in providing an event closer to the social optimum, into trading off these costs so as to secure the social benefits of winning the event.

II. A Model of Multi-Dimensional Bidding Here we consider interstate rivalry over a single event. This paper takes as given that certain states have decided to bid for the event. Considering states’ decisions to bid are beyond the scope of this paper and are discussed in more depth in a companion paper (Gans, 1996). Initially, I assume that state government’s choose strategies that maximise the social benefit of adopting the event less its social cost which arises from a diversion of financial resources to acquire the event. Let the social value of an event to state i be represented by vi and x its acquisition cost. Then, if it wins the event, i receives v i - C(x), where C is a

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Virtually no theoretical work exists on the effects of competition between governments for major events and investment projects. There is, however, a literature on governmental rivalry over taxation, regulation and public good provision in the face of footloose firms and workers (see, for example, Tiebout, 1956; Wilson, 1986; Oates and Schwab, 1988; Wildasin, 1988; and Markusen, Morey and Olewiler, 1992). The concerns from this literature surround the implications of this competition for the overall economic performance of a region rather than changes a government’s bidding strategy.

4 convex, increasing cost function.2 Without loss in generality, this function is assumed to be the same across states. I assume that the social value of not winning the event is zero.3 The acquisition costs of an event arise from the compensation and other expenditures that form part of the bids to the “Event Promoter,” hereafter referred to as the “promoter.” This promoter has decision-making power over who gets to hold an event and, indeed, if it is held at all. There are two considerations driving the promoter’s

decisions. First, there is the total amount of compensation for the event. This can involve both monetary and non-monetary components, but since it is the transfer element of this that is of interest here, this compensation is represented by the single variable, x. Second, the promoter may receive payments contingent upon the success or other characteristics of the event. For instance, this might include the royalties from television rights. If the intensity of characteristics of an event that generate high royalties are the same as that generating social value, then this component is an increasing function, π , of the actual social value of the event. The focus here will be on situations in which the intensity with which the promoter values certain characteristics differs from that which maximises social value to the state. Therefore, suppose that the promoter’s payoff depends only indirectly on the social value of the event. It may depend on some characteristics that enhance social value but not on others. For instance, in Formula One racing, the relevant promoter receives television royalty payments. Governmental choices that enhance these royalties may be in conflict with those that maximise the social value of the event. Television ratings are improved the more picturesque the event’s setting, although this may conflict with environmental concerns. Similar conflicts can occur over ticket pricing levels, if the promoter receives a share of gate receipts. Higher ticket prices may reduce the spillover profits from tourism something not internalised in the promoter’s objectives. Thus, for a government trying to
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A greater transfer to the promoter limits the government’s ability to undertake other projects, raising the marginal opportunity cost of x. 3 There is evidence that the major proportion of tourists coming to major events are from other states within Australia and that their expenditures represent switching in the sense that these would have taken

5 win an event, there is pressure to offer to put on an event that is somewhat distinct from that which will maximise social value. This notion can be expressed formally by supposing that the promoter places weight on a single variable, y, that itself influences the social value of the event. That is, both π and vi are functions of y. But while π is strictly increasing in y, vi is assumed to be a strictly concave function of y -- increasing to a point yi* and decreasing thereafter. Thus, any state would prefer to offer an event with input, yi* , while the promoter would prefer a higher variable. So, in addition to the differing preferences over compensation, each government and the promoter have differing preferences over the nature of the event. Moreover, yi* could differ among states, something that could influence relative competitive strengths in interstate rivalry. Figure 1 depicts the preferences of the promoter and state 1. Promoters prefer points with greater levels of x and y, i.e., a higher indifference curve represents a higher payoff, x + π (y). The bold line labeled ZP1 represents the combination of events and compensation level that generate zero payoffs for state 1, i.e., v1 ( y) − C( x ) = 0 . For a given y, the state prefers outcomes with a lower level of x, i.e., lower indifference curves.4 Also note that indifference curves associated with high state payoffs are more concave than ones with low payoffs because the marginal rate of substitution of y for x becomes smaller at lower levels of compensation.5 Any outcome of the bidding game occurs on the tangency of the promoter’s and the winning state’s indifference curves. In general, there will be many such tangencies along

place anyway, but in a different location (Mules, 1995). Thus, states may face a prisoners’ dilemma forcing them into bidding competition (see Gans, 1996). 4 Note that regardless of the level of x paid, the level of y that maximises the social value of the event stays the same. This is because of the additive separability of the state payoff in x and y. Considering a less restrictive functional form would not alter the results here in any major way. 5 The slope of the state’s indifference curve is: dx dy = vi′ C ′ . For given y, since C is convex, this slope is increasing in x.

6 the contract curve.6 Any other position will not be an equilibrium since one party could alter its bid and improve its payoff without reducing the payoff to the other.7 The actual outcome that occurs depends on the relative bargaining position for the two parties. As a benchmark, suppose that if state 1 bids against another international opponent it wins the event with the bid pair ( x , y ) . It reflects the general notion that the differing preferences generate an event distinct from the social optimum. Figure 1: Outcome Without Interstate Rivalry Compensation (x)

Promoter's Preferences Contract Curve State Government's Preferences

x

ZP1

0

y1

*

y

Event Type (y)

State competition exacerbates this distortion. Figure 2 depicts a possible zero payoff line for state 2, labeled ZP2 (i.e., the set of points (x,y) such that

Formally, the contract curve for state 1 is the set of points (x, y) such that the marginal rates of substitution for state 1 and the promoter are equal, i.e., {( x , y ) −π ′( y ) = v ′( y ) / C ′( x )} . The slope of the promoter’s indifference curves are always negative, hence, the equilibrium outcome always lies on the downward sloping portion of the state’s indifference curve. The equilibrium outcome always involves a y greater than the social optimum for the state. Moreover, since the slope of the state’s indifference curve is increasing in x, the contract curve will be monotonically increasing in x. 7 This suggests that the bargaining outcome is efficient in the manner of Coase. Recall though that efficiency here does not consider the benefits to the promoter, only to the state.

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7 v2 ( y) − C( x ) = 0 ).8 Observe that it lies above the point ( x , y ) meaning that it is a viable competitor. State 2’s optimal bid is ( x2 , y2 ) -- on the indifference curve that gives it a zero payoff (bold). In attempting to win, 2 makes an offer that maximises the promoter’s payoff subject to its receiving a non-negative return on the event. To meet this bid, 1 must make an offer that is on the same or higher indifference curve for the promoter. assumption of viable competition implies that it is forced to set y1 > y . The

Therefore, in

addition to higher monetary compensation paid for events, there is an event distortion cost. The magnitude of this cost is y1 − y . 9 This cost is greater, the more y improves the social value of the event for state 2 and the higher is the rate of increasing costs to x (i.e., the greater is the convexity of C).10 Figure 2: Distortion from Competition Compensation (x)

Contract Curve ZP2 x2 x1 x ZP1

0

y1

*

y y2 y1

Event Type (y)

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This zero payoff line is positioned so that state 2 is a viable competitor, that is, ( x , y ) ∈ {( x , y ) v2 ( y ) − C( x ) ≥ 0} . 9 The monotonicity of the contract curve is the critical feature driving this result. Note that this comes because of the assumption that there are wealth effects present in state government preferences. If C(x) was linear, the contract curve would be vertical, independent of x. In this case, y will still be above its social optimum in the absence of interstate rivalry, but competition would not result in any further distortion. 10 Note that it is possible that y2 < y , that is, state 2 makes a bid closer to 1’s social optimum than the individual negotiation outcome. However, somewhat paradoxically, this competition still forces y2 > y because of the monotonicity of the contract curve.

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Note, however, that it is now possible that the state that would ordinarily value the event less could win the event. This possibility is depicted in Figure 3. Thus, there is the potential for a selection cost. Without interstate rivalry, the event would have been valued at v1 ( y ) . However, the value of the event adopted is only v2 ( y2 ). This value is less than the non-competitive outcome and is a cost over and above event distortion cost. Note, however, it is possible that the event distortion cost could be smaller rather than larger depending on whether the optimal event for state 2 involves a greater level of y than that for 1. Figure 3: Selection Cost

Compensation (x)

x1 x2

ZP2

x

ZP1

0

y1 y

*

y1

y2

Event Type (y)

In summary, the ability to select the type of event alters the nature of the bidding between state governments. In general, if the event promoter prefers one characteristic above others and this is inconsistent with state preferences, the actual event held will be different from that which is socially optimal for the state. In this case, interstate rivalry imposes additional costs on the winning state. It results in a further distortion of the event

9 type from the social optimum and in some situations can result in the state that would ordinarily value the event least, winning and holding the event. To the extent that events distinct from the social optimum change the influence of various community groups, such distortions can lead to more community protests about aspects of the event.

III.

Political Motives Thus far, the assumption has been made that governments wish to select the type of

event that maximises the social value of the event for their state. It is possible, however, that political considerations could mean that the government’s preferences are not aligned with those of its constituents. For instance, a politician may incur a private benefit or cost in choosing y that is not reflected in the social value of the event for the state. This may reflect differing concerns over environmental damage or the value to key interest groups. What does the introduction of political motives do to the welfare analysis of interstate competition discussed in the last section? A very simple way to represent these political motives is to suppose that the preferences of politicians are the sum of the social value and the political benefit or cost. That is, the payoff to the politician in state i from winning the event with a bid of (x,y) is: vi ( y) − C( x ) + ρi y If ρi = 0, there are no political considerations. If ρi is positive, the politician overvalues y and if it is negative, y is undervalued. Implicit here is an assumption that x does not entail any political trade-offs. This assumption is made of simplicity, although, it would not be difficult to show that if x is politically costly (beneficial), less (more) will be paid that the previous analysis. The effects of competition are different depending upon the political motives of each state. First, consider the case where state 1 has a government with political motives but state 2 does not (i.e., ρ2 = 0 ). In Figure 4, the ZP1Pol curve depicts the combinations of

10 (x,y) that result in the politician in state 1 receiving a zero payoff (when ρ1 > 0 ) and ZP1Soc and ZP2Soc depict the zero social payoff curves for states 1 and 2. The remaining

indifference curves are associated with that of the politician in state 1 and the promoter. The outcomes (both with and without competition from 2) all lie on the contract curve between the politician in 1 and the promoter. When ρ1 > 0 , the distortionary costs of competition are reinforced by political motivations, although it is possible that the monetary transfer is lower and the selection cost is avoided. Figure 4 demonstrates a case when the event distortion cost of competition is positive. If the positive political considerations are large it is possible that the state that wins the event may not be the state that values it the most socially. That is, there could be a selection cost. This selection cost, however, is slightly different from the one discussed previously in that political motivations alone could be driving it. Figure 4: Political Motives -- Costly Competition Compensation (x)

ZP

Soc 2

ZP1

Pol

x2 x1 x

Contract Curve

ZP1

Soc

0

y1

*

y2 y y1

Event Type (y)

When ρ1 < 0 , the opposite can occur. In this case, social preferences are more aligned with the promoter’s preferences than are the politician’s preferences. This could happen because the politician may respond to interest groups that favour events with a

11 lower y. Here competition can have a welfare enhancing effect by increasing y towards the social optimum. Competition forces the politician to trade-off the political costs of event type with the costs associated with losing the event. An example of this is depicted in Figure 5. This is an extreme example in which competition actually allows the socially optimal event to be held. This is something that would not have occurred had there been no political motives. Figure 5: Political Motives -- Beneficial Competition Compensation (x)

ZP2

Soc

ZP1

Pol

ZP1 x2 x1 x Contract Curve

Soc

0

y2 y y1 y1
*

Event Type (y)

Finally, it is possible that a state that might not enter into the bidding competition because its social zero payoff curve lies below the outcome in the absence of competition, might become competitive because the political value of the event is positive (e.g., ρ2 > 0 ). Of course, it is the relative political motivations that matter here. It is also possible that when competition is beneficial, the political costs in state 2 might prevent a bid from that state that would have otherwise improved the social welfare of constituents in state 1. A complete analysis of all of the potential implications of alternate specifications of political motivations is, however, suggestive. The analysis here shows, however, that observations

12 of costly distortions and other effects of competition must be judged carefully if one believes that political motivations are likely to be present.

IV.

Conclusions Do such costs appear to have manifested themselves in the recent prominent cases

of interstate rivalry over events? To the extent that some of these events (the Formula One and Motor Cycle Grand Prix) have switched between states, there is evidence that more than one state is a viable competitor for these events and hence, competition is likely to have an effect on negotiated outcomes. In such cases, the competition would most

probably have bid up the compensation paid for these events. However, the amounts paid are not public knowledge (The Bulletin, 11/1/94, p.73). But there is also the possibility that the nature of the event held was different from that which would have been socially optimal. characteristics of the event. Certainly, there is discretion over

The Grand Prix can have more or less regulations on

environmental harm, the type of sponsorship, ticket prices, the location of the event and its timing (the Melbourne Formula One race will be in March -- the Season’s beginning -rather than in November as it was in Adelaide, its end). But similar considerations

surround tax concessions and other details that were part of the recent Fox studios development in the Sydney Showgrounds. All of these characteristics could have been part of bidding strategies and, to the extent that there was interstate competition, their choice could have been distorted from what might be socially optimal. Such distortions could account for some of the community protests over characteristics of these events (e.g., local environmental concerns for the Grand Prix and Fox studios). But these considerations must be tempered by the possibility the political motivations could have been exacerbated or mitigated by interstate competition. Finally, it is even harder to consider evidence on whether there were selection costs. New South Wales never earned as much out of the Motor Cycle Grand Prix than Victoria (Age, 16/11/95). But this could have been as much because of silent bidding

13 resulting in a “winner’s curse” than of the real selection cost as discussed in this paper (see Gans, 1996, for a further discussion). As such, a proper evaluation of all these costs would require a more careful empirical analysis. Similar considerations apply to the

potential Federal policy institutions (e.g., similar to those that coordinate bidding for the Olympic and Commonwealth Games) that could be designed to reduce some of these costs of interstate rivalry. These issues are, however, left for future work.

14 References

Gans, J.S. (1996), “Of Grand Prix and Circuses,” Australian Economic Review, 3rd Quarter, (forthcoming). Markusen, J.R., E.R. Morey & N. Olewiler (1992), “Noncooperative Equilibria in Regional Environmental Policies When Plant Locations are Endogenous,” Working Paper, No.4051, NBER. Mules, T. (1995), “The Economic Impact of Special Events,” paper presented at the Regional Economic Issues in Australasia Conference, UNSW. Oates, W.E. & R. Schwab (1988), “Economic Competition among Jurisdictions: Efficiency Enhancing or Distortion Inducing?” Journal of Public Economics, 35, pp.33-354. Tiebout, C.M. (1956), “A Pure Theory of Local Expenditures,” Journal of Political Economy, 64, pp.416-424. Wildasin, D.E. (1988), “Nash Equilibria in Models of Fiscal Competition,” Journal of Public Economics, 35, pp.229-240. Wilson, J.D. (1986), “A Theory of Interregional Tax Competition,” Journal of Public Economics, 19, pp.296-315.

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