Race To The Bottom - Theory

Theory

Races to the bottom can be described in game theory by the prisoner's dilemma. This is an exercise in which the optimal outcome for the entire group of participants results from cooperation of the participants, but it is put in danger by the fact that the optimal outcome for each individual is to not cooperate while the others do cooperate.

An economic example of racing to the bottom is tax competition between governments. Each government may benefit from higher tax revenues by having high tax rates on corporate profits, but governments can benefit individually with lower corporate tax rates relative to other jurisdictions in order to attract businesses to their own jurisdictions. In order to maintain equilibrium, each of the other governments would have to lower their corporate tax rates to match that of the government that first lowered the tax rate. The end result is that each government adopts a lower corporate tax rate and, therefore, collects less revenue overall. Assuming the foundational premise is correct, the optimal option for all governments would be an agreement to maintain tax harmonization.

A race to the bottom can occur in deregulated private industries as well. One such example would be the subprime mortgage crisis. Banks assume credit risk when they issue mortgages, but can charge higher fees by originating mortgages to the less credit-worthy. Novel financial products, coupled with securitization of mortgages and credit default swaps, led to a race to the bottom of lending standards and risk management.

The occurrence of races to the bottom is mitigated by the costs of moving investment and production between jurisdictions; the persistence of comparative advantages such as skilled workforces, infrastructure, or proximity to natural resources; and the presence of minimum standards, rules or conventions which prevent them.