Market Misallocation, Entry Bias, and Regulation

Abstract

This paper provides a tractable equilibrium model with firm heterogeneity to show a new kind of market failure. In the model, resources are excessively skewed toward the products with lower fixed costs of production, thus there exists both excessive entry in products with low fixed costs and insufficient entry in varieties. Market expansion has gains because it brings more drastic competition and new varieties with higher fixed costs of production. A break-even tax-subsidy scheme for the firms is proposed to regulate excessive entry and insufficient entry simultaneously. I show that the first-best social optimum can be achieved when the firm's free entry and independent choice of output and price are retained and taxing or subsidizing the consumers is not needed.

Keywords: Welfare distortions; Entry bias; Regulation; Tax-subsidy scheme

JEL Classification: D42; D61; L53; H11