Abstract: Governments in many middle income countries promote the interests of a small set of firms while erecting barriers to entry and threatening the property rights of other economic actors. We show how such economic favoritism yields second-best outcomes that are nevertheless welfare-superior to scenarios with no property rights, but fall short of the first-best outcome of free entry and open competition. We develop a model to explain how such policies are politically feasible and can be optimal from the perspective of rulers when first-best policies are not. We illustrate the political economy of middle income countries with the examples of Suharto’s Indonesia, Mexico under Porfirio D´ıaz, and Thailand in the second half of the 20th century.


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