The impossible trinity: Competitive markets, free entry, and efficiency

Abstract

We present a model in which workers make occupational choices and vote over a tax rate which determines the level of government spending. Workers in occupations whose services are in high (low) demand by the government favor high (low) taxes. We show that the socially efficient size of the public sector cannot be supported in a political economic equilibrium. The reason is that equilibrium tax rates always reward excessive entry into the politically most powerful sector, and thus the equilibrium size of government is always either too big or too small. We show that this is an example of a more general political economy result that extends well beyond the baseline model and holds quite generally: the combination of (i) competitive markets and (ii) free entry is inconsistent with (iii) allocative efficiency.