Optimal mechanism of transfer payments to cost-varying firms

After a trade shock, allocating efficiently funds to ease firms’ adjustment into a new trade regime becomes one of the planners’ greatest challenges. I examine the optimal mechanism that determines the amount and distribution of the transfer payments to cost-varying firms losing preferential access to an export market. The planner wants to pay firms on the basis of their types of sunk cost over a finite period of time, but it has no information on the firms’ true sunk costs and must find a way to make the firms commit to the payment contracts. Employing a recursive approach, I show that the implementable mechanism requires a tradeoff between the transfer payments to firms in the current period and the continuation value of the transfer payments in the next period. Using a quadratic functional form for the promised continuation value, the analysis provides some implicit optimal solutions for the transfer payments. The main findings are that the optimal mechanism of the transfer payments requires that the payments decrease over time, especially when the commitment constraint and the pressure to not withhold any funds at the end of the adjustment period are binding. More importantly, the feasible domain for the disbursement mechanism with a decreasing (increasing) payment over time widens when the speed of the phasing out of the preferential access is positively (negatively) correlated with the rate of the release of the payments.