© 2005 pearson education canada inc. 18.1 chapter 18 asymmetric information, the rules of the game,...

© 2005 Pearson Education Canada Inc.18.1

Chapter 18Chapter 18

Asymmetric Information, The Rules Asymmetric Information, The Rules of the Game, and Externalitiesof the Game, and Externalities


Externalities and Externalities and The Coase TheoremThe Coase Theorem

When someone’s behaviour increases or When someone’s behaviour increases or decreases another’s utility or profit, we decreases another’s utility or profit, we say that the agent is imposing an say that the agent is imposing an externality (positive or negative) on the externality (positive or negative) on the person affected.person affected.

Property rightsProperty rights refer to the legally refer to the legally established titles to ownership, use and established titles to ownership, use and disposal of factors of production and disposal of factors of production and goods and services.goods and services.


The Coase Theorem Part 1:The Coase Theorem Part 1:

When information is free, the When information is free, the

allocation of resources is independent allocation of resources is independent of the distribution of property rights, of the distribution of property rights, and the allocation is Pareto-optimal.and the allocation is Pareto-optimal.


Information Costs, Transaction Information Costs, Transaction Costs, and Property RightsCosts, and Property Rights

Economic propertyEconomic property consists of the consists of the ability to exercise choices freely.ability to exercise choices freely.

Transaction costsTransaction costs are the costs of are the costs of establishing and maintaining establishing and maintaining property rights.property rights.


Information Costs, Transaction Information Costs, Transaction Costs, and Property rightsCosts, and Property rights

If transaction costs are zero, then If transaction costs are zero, then economic property rights are complete, economic property rights are complete, wealth is maximized and the Coase wealth is maximized and the Coase Theorem holds.Theorem holds.

If transaction costs are positive and If transaction costs are positive and significant, then property rights will be significant, then property rights will be incomplete, the Coase Theorem will not incomplete, the Coase Theorem will not hold.hold.

If Transaction costs are so large that If Transaction costs are so large that property rights are absent, we have a property rights are absent, we have a world of anarchy. world of anarchy.


Externalities with Positive Externalities with Positive Transaction CostsTransaction Costs

The farmer chooses the amount of grain to The farmer chooses the amount of grain to plant that maximizes his profits, assuming plant that maximizes his profits, assuming the rancher will run a given number of the rancher will run a given number of cattle.cattle.

The rancher decides how many cattle to The rancher decides how many cattle to run to maximize his profits, assuming the run to maximize his profits, assuming the farmer will plant a certain amount of grain.farmer will plant a certain amount of grain.


Externalities with Positive Externalities with Positive Transaction CostsTransaction Costs

A farmer and a rancher can both A farmer and a rancher can both make use the same land because make use the same land because there is no fence. there is no fence.

The more cattle there are, the lower The more cattle there are, the lower the profit of the farmer (cattle eat the profit of the farmer (cattle eat the farmer’s grain) and the more the farmer’s grain) and the more wheat that is grown, the higher the wheat that is grown, the higher the profits of the rancher (the cattle are profits of the rancher (the cattle are well fed).well fed).


Figure 18.1 The rancher-farmer externalityFigure 18.1 The rancher-farmer externality


From Figure 18.1 From Figure 18.1

In Figure 18.1 a), as indicated by the arrows, In Figure 18.1 a), as indicated by the arrows, profits to the rancher are increasing as the profits to the rancher are increasing as the amount of wheat increases.amount of wheat increases.

In Figure 18.1b) The more cattle there are the In Figure 18.1b) The more cattle there are the lower profits are for the farmer, the farmers lower profits are for the farmer, the farmers profits increase to the left of point A.profits increase to the left of point A.


From Figure 18.1 From Figure 18.1

In part c) point A is the Nash equilibrium, In part c) point A is the Nash equilibrium, as C* is the best output given the farmer is as C* is the best output given the farmer is producing W* and W* is the best output producing W* and W* is the best output given that the rancher is producing C*.given that the rancher is producing C*.

Point A is not Pareto-optimal since both Point A is not Pareto-optimal since both the rancher and farmer can earn greater the rancher and farmer can earn greater profits by producing in the shaded region profits by producing in the shaded region (more wheat and less cattle).(more wheat and less cattle).


Responses to ExternalitiesResponses to Externalities

When externalities are positive When externalities are positive resources are resources are underallocated. underallocated.

When externalities are negative, When externalities are negative, resources are resources are overallocated.overallocated.

When there is an externality, there is When there is an externality, there is always a opportunity to try and avoid always a opportunity to try and avoid it and increase the gains from trade. it and increase the gains from trade.


Assigning Property RightsAssigning Property Rights

Transaction costs would have to be Transaction costs would have to be reduced in order to deal with the reduced in order to deal with the externalities and reach the Pareto-optimal externalities and reach the Pareto-optimal outcome.outcome.

If property rights were assigned to the If property rights were assigned to the rancher, the outcome would be at point A rancher, the outcome would be at point A in Figure 18.1.in Figure 18.1.

If property rights were assigned to the If property rights were assigned to the farmer, the outcome with no bargaining farmer, the outcome with no bargaining would be at point F in Figure 18.1b)would be at point F in Figure 18.1b)



With the assignment of property rights and With the assignment of property rights and no bargaining, the outcomes tend to be no bargaining, the outcomes tend to be extreme and we end up with either too extreme and we end up with either too many or too few cattle.many or too few cattle.

The assignment of property rights to the The assignment of property rights to the right party does not eliminate the right party does not eliminate the externality but maximizes the gains from externality but maximizes the gains from trade in light of the externality.trade in light of the externality.



The assignment of property rights is most The assignment of property rights is most effective when it is well known who effective when it is well known who commits the externality. In such cases the commits the externality. In such cases the damages are well known and bargaining damages are well known and bargaining can take place.can take place.

The assignment of property rights The assignment of property rights enhances the wealth of some parties while enhances the wealth of some parties while lowering that of others.lowering that of others.



Internalization is a process in which a third Internalization is a process in which a third party, seeing an opportunity to make a private party, seeing an opportunity to make a private gain intervenes between the source(s) and the gain intervenes between the source(s) and the recipient(s)recipient(s) (Smoking/non-smoking hotel (Smoking/non-smoking hotel rooms).rooms).

When problems are not privately resolved, When problems are not privately resolved, governments may impose governments may impose public regulationpublic regulation, , based on cost-benefit analysis, or it may take based on cost-benefit analysis, or it may take no action at all. no action at all.


Figure 18.2 The costs and benefits of smokingFigure 18.2 The costs and benefits of smoking


NoninterventionNonintervention

Because regulation itself uses up Because regulation itself uses up resources, including gathering information resources, including gathering information costs, administration and enforcement, the costs, administration and enforcement, the best policy may be to do nothing.best policy may be to do nothing.

Coase Theorem Part 2:Coase Theorem Part 2:

When transaction costs are prohibitive, When transaction costs are prohibitive, economic activities are organized to economic activities are organized to maximize gains from trade net of maximize gains from trade net of transaction costs. transaction costs.


Public GoodsPublic Goods

Public goods can be characterized by:Public goods can be characterized by:

1.1. Non-rivalrous-the good/service can be Non-rivalrous-the good/service can be consumed by a number of persons consumed by a number of persons simultaneously.simultaneously.

2.2. Non-excludable-meaning that denial of Non-excludable-meaning that denial of access to the good or service is not access to the good or service is not possible or very costly.possible or very costly.


Pure Public GoodsPure Public Goods

Goods that are both completely non-Goods that are both completely non-rivalrous and non-excludable are rivalrous and non-excludable are called called pure public goods.pure public goods.

They tend to be produced by some They tend to be produced by some public authority rather than by profit-public authority rather than by profit-seeking firms because firms find it seeking firms because firms find it costly to enforce contracts for non-costly to enforce contracts for non-excludable goods.excludable goods.


Figure 18.3 The private provision of a public goodFigure 18.3 The private provision of a public good


Figure 18.4 Provision of a pure public goodFigure 18.4 Provision of a pure public good


Asymmetric Information and Asymmetric Information and Revealed PreferenceRevealed Preference

Implementing cost-benefit analysis to Implementing cost-benefit analysis to public goods can be difficult because of public goods can be difficult because of asymmetric information.asymmetric information.

The problem is that individual citizens may The problem is that individual citizens may have private incentives not to reveal their have private incentives not to reveal their actual preferences for public goods. actual preferences for public goods.

Citizens may understate or overstate their Citizens may understate or overstate their actual values of a public good, depending actual values of a public good, depending on the incentives/implications of doing so.on the incentives/implications of doing so.

© 2005 pearson education canada inc. 18.1 chapter 18 asymmetric information, the rules of the game,...

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