Lecture 3

Question 1

In theory, players can make ____, so that the efficient option is chosen. Sometimes, the efficient strategy leads to one of the players being worse off than the inefficient strategy. Such problem can be solved by ___. “A larger cake can always be cut so at least one gets more while the rest get the same”.

Which word is missing?

Answer 1

Side-payments

If you don’t compensate those who will lose from a change (leading to higher efficiency), they will resists.

Question 2

There are two situations where their corresponding assumptions suggests that markets can reach efficiency, eliminating the need for firms. These situations result in the “first best” outcomes.

What are these situations?

Answer 2

1) Fundamental Welfare Theorem
2) The Coase Theorem

Question 3

Can firms reach the “first-best” outcomes?

Answer 3

No - “first-best” outcomes describe situations in which markets can reach efficiency, thus eliminating the need for firms.
Firms cannot reach such benchmarks, but they can approximate them - leading to “second-best” outcomes if perfect market assumptions are relaxed

Question 4

Under the Fundamental Welfare Theorem, perfect competition is efficient - if each firm maximizes profits and each customer maximizes utility, and there is a supply and demand equilibrium, efficiency is reached.

Is this TRUE/ FALSE?

Answer 4

TRUE

Question 5

Under the Fundamental Welfare Theorem, the allocation of goods and services is Pareto optimal if following holds (multiple options may be correct)

A) Each firm maximizes its profits, knowing the prices and its own production technology
B) Each consumer maximizes utility, knowing the prices and his own preferences
C) Income and prices are such that demand equals supply for every good and service
D) Positive externalities are present

Answer 5

CORRECT:
A) Each firm maximizes its profits, knowing the prices and its own production technology
B) Each consumer maximizes utility, knowing the prices and his own preferences
C) Income and prices are such that demand equals supply for every good and service

WRONG:
D) Positive externalities are present

Question 6

Which of the following are NOT assumptions of the Fundamental Welfare Theorem?
A) Large number of consumers and producers
B) Law of one price
C) Anonymity
D) Production function view of firm
E) Communication structure entails the Walrasian auctioneer at the center
F) Contracts are complete contingent
G) Complete rationality
H) Presence of motivation problems
I) Decentralization
J) No coordination problems
K) Complete set of markets
L) No externalities
M) All goods and services can be exchanged
O) All of the above are correct

Answer 6

WRONG:
H) Presence of motivation problems
O) All of the above are correct

Question 7

Essentially, the Fundamental Welfare Theorem assumes a perfect market allowing the elimination of any coordination and motivation problems - and therefore no need for firms since markets can reach the “first-best” outcomes.

Is this TRUE/FALSE?

Answer 7

TRUE

Question 8

Which of the following statements are correct about Externalities? (Multiple options may be correct)

A) externality is a result of an activity that causes benefits (costs) to others with no corresponding compensation provided to (paid by) those who generate them
B) externalities destroys value and lead to inefficient outcomes
C) imposing taxes (subsidies) on activities that generate negative (positive) externalities is a solution for reaching efficiency
D) one can internalize activities through M&A
E) creating a market for externalities (defining property rights) solves the inefficiency issue

Answer 8

CORRECT: all options are true

Question 9

Following Coase, a third way for dealing with externalities is the creation of a market for externalities.

How/Why?

Answer 9

A basic problem with externalities is the wrong allocation of ownership rights: If a choice is accompanied by the legal responsibility for its effects, there is no problem with externalities.

Question 10

Following the Coase Theorem, the efficient amount of externalities will always be reached regardless of the allocation of property rights.

Why so?

Answer 10

Efficient bargaining: the players will trade externality rights until equilibrium is reached. As such, the initial allocation of property rights does not impact efficiency - only how the pie is sliced

Question 11

Which are the three assumptions of the Coase Theorem?
A) Property rights are defined, allocated, and enforced
B) Bargaining is efficient
C) No externalities
D) Preferences do not exhibit wealth (income) effects

Answer 11

A) Property rights are defined, allocated, and enforced
B) Bargaining is efficient
D) Preferences do not exhibit wealth (income) effects

WRONG: C) No externalities –> this is an assumption of the Fundamental Welfare Theorem

Question 12

The Coase Theorem states that if
1) Property rights are defined, allocated, and enforced,
2) Bargaining is efficient
3) Preferences do not exhibit income (wealth) effect
, then:

A) Players will only be subject to motivation problems, not coordination problems
B) Every allocation of property rights in externalities result in a Pareto-efficient allocation
C) Asymmetric information has no impact on the division of wealth
D) The amount of damage produced is invariant to the allocation of property rights

Answer 12

A) Players will only be subject to motivation problems, not coordination problems (PLAYERS FACE NEITHER UNDER THE CT)

B) Every allocation of property rights in externalities result in a Pareto-efficient allocation (TRUE)

C) Asymmetric information has no impact on the division of wealth (FALSE - EFFICIENCY IS STILL REACHED, BUT DIVISION MAY BE DIFFERENT)

D) The amount of damage produced is invariant to the allocation of property rights (TRUE)

Question 13

Following the CT, with efficient bargaining, the relative bargaining power of each player has no effect on the division of costs and benefits

TRUE/FALSE

Answer 13

FALSE: Efficient bargaining means there are no problems in realizing the creation of the maximum value. If this is the case, the bargaining power affects ONLY THE DIVISION OF COSTS AND BENEFITS, not the size.

Question 14

According to the CT, efficient bargaining (bargaining to efficiency) will materialize when… (multiple May be correct)

A) There is no information asymmetry
B) There are no wealth effects: divisions of players don’t depend on their financial position
C) Activities are internalized through M&A
D) Transaction costs are zero (bargaining is costless)

Answer 14

B) There are no wealth effects: divisions of players don’t depend on their financial position
D) Transaction costs are zero (bargaining is costless)

Question 15

What does “no income (wealth) effect” mean? (Multiple options may be correct)
A) choices can be expressed in money
B) choices do not depend on wealth position
C) there are no financial restrictions regarding establishing a deal
D) all of the above

Answer 15

D) all of the above

Question 16

No wealth effect is under no circumstances realistic assumption in reality

TRUE/FALSE

Answer 16

FALSE: no wealth effect can be a realistic assumption when the amount of money involved in making the decision (e.g., trading externality rights) is small relative to the financial position of the decision-maker.

I.e., there are no financial restrictions regarding establishing a deal

Question 17

Which of the following statements are NOT TRUE?

A) Transaction costs are not zero in the real world: indeed, costs of bargaining; defining, delineating, exchanging, enforcing property rights are all increasing transaction costs.
B) There are no wealth effects in the real world: organizational choices seldomly depend on the financial abundance of the firm
C) In many of the developing countries, property rights are ill-defined, which limits the owners to use the assets as collateral - limiting their ability to raise capital and become richer

Answer 17

WRONG: B) There are no wealth effects in the real world: organizational choices seldomly depend on the financial abundance of the firm

There are wealth effects in the real world: e.g., getting a raise at work increases my demand for eating out. Choices are indeed affected by one’s wealth.

Question 18

Under communism (lack of private property rights), there is likely overproduction.

TRUE/FALSE

Answer 18

TRUE: private (clearly defined) ownership leads to higher efficiency - i.e., overproduction results from lack of property rights

Question 19

The Coase Theorem argues that “it does not matter how property rights are defined but it is crucial that they are assigned”

TRUE/FALSE

Answer 19

TRUE: with the assumptions of zero-transaction costs (zero bargaining costs) and that property rights are assigned and enforceable by institutions; how the property rights are defined has no implication on outcome efficiency

Question 20

Determining the circumstances in which the conditions of the CT are not met is important, because this is fertile ground for the rise of institutions or organizations other than markets that will reduce the inefficiencies of exchange via markets.

TRUE/FALSE

Answer 20

TRUE

When bargaining turns out not to be efficient, and/or when income effects do play a role, the Coase Theorem does no longer hold

Question 21

An important contribution of the CT is the institutional aspect – like legal status and ownership rights – are given a more prominent role than in the fundamental welfare theorem.
The CT emphasizes that a variety of institutions are necessary to make the market mechanisms function well.

TRUE/FALSE

Answer 21

TRUE: the allocation of ownership rights, the design of contracts, and the choice of the institutional framework are no longer exogenously given – but are now important objects of analysis.