DP8533 Can Market Failure Cause Political Failure

Author(s): Madhav Aney, Maitreesh Ghatak, Massimo Morelli
Publication Date: August 2011
Keyword(s): adverse selection, asset liquidation, market failure, occupational choice, political failure, property rights
JEL(s): O12, O16, O17
Programme Areas: Public Economics, Industrial Organization
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=8533

We study how inefficiencies of market failure may be further amplified by political choices made by interest groups created in the inefficient market. We take an occupational choice framework, where agents are endowed heterogeneously with wealth and talent. In our model, market failure due to unobservability of talent endogenously creates a class structure that affects voting on institutional reform. In contrast to the world without market failure where the electorate unanimously vote in favour of surplus maximising institutional reform, we find that the preferences of these classes are often aligned in ways that creates a tension between surplus maximising and politically feasible institutional reforms.