© 2005 Pearson Education Canada Inc Chapter 18 Asymmetric Information, The Rules of the Game, and Externalities

© 2005 Pearson Education Canada Inc Externalities and The Coase Theorem  When someone’s behaviour increases or decreases another’s utility or profit, we say that the agent is imposing an externality (positive or negative) on the person affected.  Property rights refer to the legally established titles to ownership, use and disposal of factors of production and goods and services.

© 2005 Pearson Education Canada Inc The Coase Theorem Part 1: When information is free, the allocation of resources is independent of the distribution of property rights, and the allocation is Pareto-optimal.

© 2005 Pearson Education Canada Inc Information Costs, Transaction Costs, and Property Rights  Economic property consists of the ability to exercise choices freely.  Transaction costs are the costs of establishing and maintaining property rights.

© 2005 Pearson Education Canada Inc Information Costs, Transaction Costs, and Property rights  If transaction costs are zero, then economic property rights are complete, wealth is maximized and the Coase Theorem holds.  If transaction costs are positive and significant, then property rights will be incomplete, the Coase Theorem will not hold.  If Transaction costs are so large that property rights are absent, we have a world of anarchy.

© 2005 Pearson Education Canada Inc Externalities with Positive Transaction Costs  The farmer chooses the amount of grain to plant that maximizes his profits, assuming the rancher will run a given number of cattle.  The rancher decides how many cattle to run to maximize his profits, assuming the farmer will plant a certain amount of grain.

© 2005 Pearson Education Canada Inc Externalities with Positive Transaction Costs  A farmer and a rancher can both make use the same land because there is no fence.  The more cattle there are, the lower the profit of the farmer (cattle eat the farmer’s grain) and the more wheat that is grown, the higher the profits of the rancher (the cattle are well fed).

© 2005 Pearson Education Canada Inc Figure 18.1 The rancher-farmer externality

© 2005 Pearson Education Canada Inc From Figure 18.1  In Figure 18.1 a), as indicated by the arrows, profits to the rancher are increasing as the amount of wheat increases.  In Figure 18.1b) The more cattle there are the lower profits are for the farmer, the farmers profits increase to the left of point A.

© 2005 Pearson Education Canada Inc From Figure 18.1  In part c) point A is the Nash equilibrium, as C* is the best output given the farmer is producing W* and W* is the best output given that the rancher is producing C*.  Point A is not Pareto-optimal since both the rancher and farmer can earn greater profits by producing in the shaded region (more wheat and less cattle).

© 2005 Pearson Education Canada Inc Responses to Externalities  When externalities are positive resources are underallocated.  When externalities are negative, resources are overallocated.  When there is an externality, there is always a opportunity to try and avoid it and increase the gains from trade.

© 2005 Pearson Education Canada Inc Assigning Property Rights  Transaction costs would have to be reduced in order to deal with the externalities and reach the Pareto-optimal outcome.  If property rights were assigned to the rancher, the outcome would be at point A in Figure  If property rights were assigned to the farmer, the outcome with no bargaining would be at point F in Figure 18.1b)

© 2005 Pearson Education Canada Inc Responses to Externalities  With the assignment of property rights and no bargaining, the outcomes tend to be extreme and we end up with either too many or too few cattle.  The assignment of property rights to the right party does not eliminate the externality but maximizes the gains from trade in light of the externality.

© 2005 Pearson Education Canada Inc Responses to Externalities  The assignment of property rights is most effective when it is well known who commits the externality. In such cases the damages are well known and bargaining can take place.  The assignment of property rights enhances the wealth of some parties while lowering that of others.

© 2005 Pearson Education Canada Inc Responses to Externalities  Internalization is a process in which a third party, seeing an opportunity to make a private gain intervenes between the source(s) and the recipient(s) (Smoking/non-smoking hotel rooms).  When problems are not privately resolved, governments may impose public regulation, based on cost-benefit analysis, or it may take no action at all.

© 2005 Pearson Education Canada Inc Figure 18.2 The costs and benefits of smoking

© 2005 Pearson Education Canada Inc Nonintervention  Because regulation itself uses up resources, including gathering information costs, administration and enforcement, the best policy may be to do nothing.  Coase Theorem Part 2: When transaction costs are prohibitive, economic activities are organized to maximize gains from trade net of transaction costs.

© 2005 Pearson Education Canada Inc Public Goods  Public goods can be characterized by: 1. Non-rivalrous-the good/service can be consumed by a number of persons simultaneously. 2. Non-excludable-meaning that denial of access to the good or service is not possible or very costly.

© 2005 Pearson Education Canada Inc Pure Public Goods  Goods that are both completely non- rivalrous and non-excludable are called pure public goods.  They tend to be produced by some public authority rather than by profit- seeking firms because firms find it costly to enforce contracts for non- excludable goods.

© 2005 Pearson Education Canada Inc Figure 18.3 The private provision of a public good

© 2005 Pearson Education Canada Inc Figure 18.4 Provision of a pure public good

© 2005 Pearson Education Canada Inc Asymmetric Information and Revealed Preference  Implementing cost-benefit analysis to public goods can be difficult because of asymmetric information.  The problem is that individual citizens may have private incentives not to reveal their actual preferences for public goods.  Citizens may understate or overstate their actual values of a public good, depending on the incentives/implications of doing so.