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Development Discussion Paper
Can Market Failure Cause Political Failure?
Madhav S, Aney, Maitreesh Ghatak and Massimo Morelli
July 2011
Paper No' EOPP 029:
Full Paper (pdf)

JEL Classification: O12, O16, O17

Tags: occupational choice; adverse selection; property rights; asset liquidation; political failure; market failure.

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.