Groupe d’études et de recherche en analyse des décisions

Short-run stick and long-run carrot policy: The role of initial conditions

Denis Claude GERAD, HEC Montréal, Canada

This paper explores the dynamic properties of price-based policies in a model of competition between two jurisdictions. Jurisdictions invest over time in infrastructures to increase the quality of the environment, a global public good. They are identical in all respects but one: initial stocks of infrastructures. This is a dynamic type of heterogeneity that disappears in the long run. Therefore, at the steady state, usual intuitions from static settings apply: identical jurisdictions inefficiently under-invest, calling for public subsidies. In the short run, however, counterintuitive properties are established: i) the evolution of capital stocks can be non-monotonic, ii) one jurisdiction can be temporarily taxed, even though it should increase its investment, whereas the other is subsidised. It is shown how these phenomena are related to initial conditions and the kind of interactions between infrastructure capitals, complementarity or substitutability.