Foreign Aid and International Public Goods: Incentives and Stratgic Behavior

This paper considers a stylized model where a donor and a recipient government derive utility from a public good (for example consumption among the poor or defense capacity in the recipient country), in addition to a private good each (for example their own tax-payers’ consumption). The main point is to discuss how the aggregate provision of funds earmarked for the public good and the distribution of the costs depend on the pattern of interaction between the two governments. Both non-cooperative interaction patterns (leading to undersupply of the public good) and cooperative patterns (leading to Pareto-efficient outcomes) are discussed. Cooperation is unlikely unless it is backed by institutions or credible sanctions. Among the non-cooperative interaction patterns the Nash-Cournot type is the best, in the sense that the supply of the public good is highest. If one of the governments behave as a (passive) Stackelberg leader (and the other as a follower) the supply is considerably lower. The distribution of the cost depends on who the leader is but it may be very uneven. If the Stackelberg leader government is active and behaves as a principal, making the other an agent, undersupply is eliminated but the distribution of the costs become even more uneven.