A Modeling Analysis of Local Governments Competing in Offering Subsidies to Attract Investment: the Cause of Industrial Overcapacity*

Jiang Feitao  1, Geng Qiang 2, Lv Daguo 3 and Li Xiaoping 4
1Institute of Industrial Economics of Chinese Academy of Social Sciences (CASS), Beijing, China
2 School of Business, Nanjing University; Institute of Industrial Economics of CASS
3School of Business, Nanjing University, Nanjing, China
4School of Business, Sun Yat-sen University, Guangzhou, China
Abstract: Although championed by academia and policy-makers, the theory of “wave phenomenon” is a questionable explanation for overcapacity. First, enterprises do not necessarily share the same expectation for future demand of a promising industry. Second, in its model, overcapacity is explained as a deviation from equilibrium under the incomplete information hypothesis, which is in fact nothing but normal in a market economy. The prime reason for overcapacity resides in the fact that local governments are engaged in a subsidy competition to attract investment. We endeavor to illustrate the following via modeling: the subsidy effect produced by local government’s offering of cheaper land and matching loans results in less investment from companies. Under this circumstance, enterprises channel a disproportionate amount of funding to building production capacity, which overloads the entire industry. To address the problem, reforms are needed in land property, environmental protection policies, and financial and fiscal systems.
Key words: overcapacity, investment subsidy, cost externalization, risk externalization

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