Lecture 3 - Efficiency, prices and property rights: Benchmarks

Question 1

Behavioral Assumptions

Answer 1

• Complete rationality
• Self-interested actors

Question 2

View of the firm

Answer 2

Production function

Question 3

2 Benchmarks

Answer 3

1. The Welfare Theorem
2. Coase Theorem

Question 4

Why are these theorems good benchmarks

Answer 4

• 2 situations where markets are efficient
  o No need for firms – First-best outcomes
  o Firms cannot reach these benchmarks, but they can approximate them – Second-best

Question 5

The fundamental welfare theorem

Answer 5

If
* Each firm maximizes its profits, knowing the prices and its own production technology
* Each consumer maximizes utility, knowing the prices and his own preferences
* Income and prices are such that demand equals supply for every good and service

Then,
* the resulting allocation of goods and services is Pareto-efficient

Question 6

Why the fundamental welfare theorem is a useful benchmark for organization theories

Answer 6

Specifies under which assumptions the price mechanism (market) solves all coordination & cooperation problems through complete contingent contracts & full information

Question 7

Limitations of the welfare theorem

Answer 7

• Assumptions of an ideal world where all coordination and cooperation problems are solved
  
  • Relax these extreme assumptions and you get coordination and cooperation problems, which firms may handle better than the market
• Assumptions
  
  • Large number of consumers and producers
  • Complete contingent contracts
  • Complete rationality
  • No externalities
• Causes for market failure
  
  • Incomplete information
  • Asymmetric information
  • Market power
  • Limited cognition
  • Externalities

Question 8

The Coase Theorem

Answer 8

If
* Property rights are defined, allocated and enforced
* Bargaining is efficient (no transaction costs)
* Preferences do not exhibit income effects (income effects occur when decisions depend on the level of wealth of the players)

Then
* Every allocation of property rights in externalities results in a Pareto-efficient allocation
* The amount of damage is invariant to the allocation of property rights, i.e., the equilibrium amount of externalities is the same regardless of the allocation of property rights

Question 9

Definition of externalities

Answer 9

Result of an activity that causes benefits (costs) to others with no corresponding compensation provided to (or paid by) those who generate the externality

Question 10

How to deal with externalities

According to Coase

Answer 10

Create a market for externalities
i.e., define property rights

Question 11

Assumptions of the Coase Theorem

Answer 11

• Decision rights & income rights are located with the same person
• Not necessary to have large number of consumers and producers
• Decentralization
• Efficient bargaining (no transaction costs)
• No income effects
• Complete contingent contracts (honored & enforced)
• Complete rationality
• Ownership rights are
  
  • Allocated
  • Implemented
  • Enforced
  • Tradable
  • Decision rights and income rights are efficiently allocated

Question 12

Limitations of the Coase Theorem

Answer 12

1. Transaction costs are not 0 in the real world
2. There are income/wealth effects

Question 13

What is efficiency

Answer 13

• Maximizing the sum of consumer & producer surplus
• Pareto efficient: can’t improve welfare without decreasing another player’s

Question 14

The relevance of efficiency to decision-making in firms

Answer 14

• More complete the contract is –> more efficient
• More complete information –> more efficient
• Less transaction costs –> more flexibility & efficient

Question 15

When efficiency can be reached through prices (markets)

Answer 15

• Low transaction costs
• High degree of complete information
• High degree of completeness of contracts