Rivalry among local governments (e.g. municipalities) regarding protection and expansion of local labor markets by means of costly policy programs is modeled as a non-cooperative game. Using a two-community example, we analyze the possible consequences of interlocal rivalry and assess local behavior through its effects on stabilization and welfare goals of the central government.

It is assumed that successful labor market policy in a community has beneficial effects on the local labor market. But such a policy is also detrimental because it deprives a neighbourinig community of employment opportunities. The model is biased by assuming that interlocal rivalry not only redistributes existing total employment among the communities, but also leads to increased employment in every community involved. This is justified as a "local mobilization effect". In addition, it is assumed that policy expenditure is financed by local taxes, as are unemployment benefits. Then, local policymakers try to maximize the gains from employment, i.e., employment benefits less policy and unemployment costs.

Game equilibrium determines the level of local policy expenditure and, indirectly, the rates of local taxes and unemployment. It is found that under some circumstances, interlocal rivalry may promote social welfare; but, under the same circumstances, policy expenditure follows a clearly procyclical pattern. Thus, a trade-off appears between stabilization and welfare goals. Under other conditions, fluctuations in policy expenditure exert only a weak influence on the business cycle, although they have considerable distributional effects.