eaton micro 6e ch18

7/27/2019 Eaton Micro 6e Ch18

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2005 Pearson Education Canada Inc.18.1

Chapter 18

Asymmetric Information, The Rules

of the Game, and Externalities


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Externalities and

The Coase Theorem

When someones behaviour increases ordecreases anothers utility or profit, wesay that the agent is imposing an

externality (positive or negative) on theperson affected.

Property rights refer to the legallyestablished titles to ownership, use anddisposal of factors of production andgoods and services.


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The Coase Theorem Part 1:

When information is free, the

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


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Information Costs, Transaction

Costs, and Property Rights

Economic propertyconsists of theability to exercise choices freely.

Transaction costs are the costs ofestablishing and maintainingproperty rights.


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Information Costs, Transaction

Costs, and Property rights

If transaction costs are zero, theneconomic property rights are complete,wealth is maximized and the CoaseTheorem holds.

If transaction costs are positive andsignificant, then property rights will beincomplete, the Coase Theorem will nothold.

If Transaction costs are so large thatproperty rights are absent, we have aworld of anarchy.


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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.


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Externalities with Positive

Transaction Costs

A farmer and a rancher can bothmake use the same land becausethere is no fence.

The more cattle there are, the lowerthe profit of the farmer (cattle eatthe farmers grain) and the morewheat that is grown, the higher theprofits of the rancher (the cattle arewell fed).


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Figure 18.1 The rancher-farmer externality


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From Figure 18.1

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

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


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From Figure 18.1

In part c) point A is the Nash equilibrium,as C* is the best output given the farmeris 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 greaterprofits by producing in the shaded region

(more wheat and less cattle).


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Responses to Externalities

When externalities are positiveresources are underallocated.

When externalities are negative,resources are overallocated.

When there is an externality, there isalways a opportunity to try and avoidit and increase the gains from trade.


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Assigning Property Rights

Transaction costs would have to bereduced in order to deal with theexternalities and reach the Pareto-optimaloutcome.

If property rights were assigned to therancher, the outcome would be at point Ain Figure 18.1.

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


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With the assignment of property rightsand no bargaining, the outcomes tend tobe extreme and we end up with either toomany or too few cattle.

The assignment of property rights to theright party does not eliminate theexternality but maximizes the gains fromtrade in light of the externality.


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The assignment of property rights is mosteffective when it is well known whocommits the externality. In such cases the

damages are well known and bargainingcan take place.

The assignment of property rightsenhances the wealth of some parties while

lowering that of others.


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Internalization is a process in which a thirdparty, seeing an opportunity to make a privategain intervenes between the source(s) and therecipient(s) (Smoking/non-smoking hotelrooms).

When problems are not privately resolved,governments may imposepublic regulation,based on cost-benefit analysis, or it may takeno action at all.


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Figure 18.2 The costs and benefits of smoking


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Nonintervention

Because regulation itself uses upresources, including gathering informationcosts, administration and enforcement,

the best policy may be to do nothing. Coase Theorem Part 2:

When transaction costs are prohibitive,economic activities are organized tomaximize gains from trade net oftransaction costs.


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Public Goods

Public goods can be characterized by:

1. Non-rivalrous-the good/service can beconsumed by a number of personssimultaneously.

2. Non-excludable-meaning that denial ofaccess to the good or service is notpossible or very costly.


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Pure Public Goods

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

They tend to be produced by somepublic authority rather than by profit-seeking firms because firms find it

costly to enforce contracts for non-excludable goods.


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Figure 18.3 The private provision of a public good


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Asymmetric Information and

Revealed Preference

Implementing cost-benefit analysis topublic goods can be difficult because ofasymmetric information.

The problem is that individual citizens mayhave private incentives not to reveal theiractual preferences for public goods.

Citizens may understate or overstate theiractual values of a public good, dependingon the incentives/implications of doing so.

eaton micro 6e ch18

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