The AI Layoff Trap

In competitive markets, firms face a powerful trap.

When AI displaces workers, each company captures the full cost savings from automation. But the resulting drop in consumer spending hurts demand across the entire market.

Because every firm bears only a small fraction of that demand loss, rational companies automate far beyond the level that would be best for the economy as a whole.

This demand externality creates an automation arms race. More competition and more powerful AI actually widen the gap between what individual firms do and what would be collectively optimal. The result is excessive layoffs that leave both workers and firm owners worse off.

Common policy fixes fall short: wage adjustments, free entry, capital taxes, worker equity, universal basic income, upskilling, and even Coasian bargaining do not fully close the wedge. Only a well-designed Pigouvian tax on automation can align incentives and prevent the trap.

Useful for anyone thinking about the long-term impact of AI on jobs, markets and economic policy.

→ Full paper: https://arxiv.org/pdf/2603.20617