Session 3: Efficiency, prices and property rights: Benchmarks

Question 1

The welfare theorem

Answer 1

Parties specialize in the task in which they have comparative advantage, which is followed by an exchange. In equilibrium, there are no possibilities left such that a more attractive outcome can be established.

Question 2

Edgeworth box

Answer 2

Illustrates the possible allocation of the two goods between two agents in an exchange. The box shows that there are many opportunities for Pareto improving trade.

Point f illustrates no trade
Contract curve: The set of points for which the two indifference curves touch (point O_T  to O_N incl. A-E).
Point B and D: Are efficient and entail a Pareto improvement for both Tim and Nancy (B best for Nancy and D best for Tim)
Point C: When adding more agents, bargaining power of the individual decreases. Then the range B-D of efficient allocations would shrink to C. This is the unique competitive equilibrium allocation

(See picture in notes)

Question 3

Pareto optimal

Answer 3

The equilibrium is Pareto optimal, because the maximum value of the sum of consumer and producer surplus is realized in every market (prices are set by supply and demand).
* Coordination: Only requires that local information and prices are known.
* Motivation: Solved because everyone is self-interested.

Question 4

Pareto efficiency

Answer 4

(i) each firm maximizes its profits, knowing the prices and its own production technology,
(ii) each consumer maximizes utility, knowing the prices and its own preferences, and
(iii) 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 5

Why the market system might fail

Answer 5

1. Incomplete information
2. Asymmetric information
3. Market power
4. Limited cognition
5. Externalities

Question 6

Law of supply and demand

Answer 6

Law of supply and demand: The equilibrium price clears the market
* Shortages disappear when the price increases
* Surpluses disappear when the price decreases

Question 7

Law of one price

Answer 7

One price is established in all markets according to the fundamental welfare theorem, for which the quantity supplied is equal to the quantity demanded.

Question 8

Walrasian auctioneer

Answer 8

All decisions are guided by an “invisible hand”, according to Adam Smith. The Walrasian auctioneer collects all information and determines equilibrium prices

All coordination and cooperation problems are solved by this communication structure.

Question 9

Other assumptions in general welfare theorem

Answer 9

Completely contingent contracts: Prevail in the theory of general equilibrium; These are specific because the assumption of complete rationality is responsible for the fact that everything can be and will be made fully contingent or dependent on every characteristic of every possible situation.

Fundamental welfare theorem assumes a large number of consumers and producers.

Complete rationality is a strong assumption of the fundamental welfare theorem.

Question 10

COASE: The Coase theorem

Answer 10

If 1) transaction costs are zero, so that bargaining is costless, and
2) there are no wealth effects, then any allocation of property
rights results in an efficient outcome

Alternative definition: If property rights are defined, allocated, and enforced and bargaining is efficient, then every allocation of property rights in externalities will result in a Pareto-efficient allocation.

Question 11

COASE: No wealth effects

Answer 11

Choices can be expressed in money; choices do not depend on wealth position; there are no financial restrictions regarding establishing a deal

Question 12

COASE: Ownership rights and externalities

Answer 12

A basic problem with externalities; If there is a discrepancy between a range of activities and the legal responsibility of those activities, it can be an issue.
* Coase suggests as a solution to create a market for externalities, in which ownership rights must be traded

Question 13

COASE: Bargaining in Coase theorem

Answer 13

Bargaining: Determines the division of the surplus generated by the activities of the players.
* The efficient bargaining assumption means there are no problems in realizing the creation of the maximum value.
* If efficient bargaining prevails, bargaining power determines only the division of costs and benefits and not the size. It leads to complete internalization of externalities.

Question 14

Graphical presentation of Coase theorem

Answer 14

See picture in notes:

X is the amount of pollution by the firm (0<x<1) and Y is the payment by the residents to the firm (negative. Positive if payment is from the firm to the residents)
A party has the property rights when it is allowed to choose the value of x, when no agreement is reached
E and E* are efficient because they are on the contract curve  The firm prefers E above E*, and residents prefer E* over E. Thus, ownership rights are attractive

Question 15

Strong version of the Coase theorem

Answer 15

Adds the assumption that: “preferences do not exhibit income effects”

Income effects: Occur when decisions depend on the level of wealth of the players. The above figure represents no income effects because the amount of pollution is identical for each point on the contract curve, regardless of the amount of money transferred.
* Not a typical situation –> Income effects are likely to occur when large amounts of money are involved in decision-making

(See picture in notes)

Question 16

Problems in bargaining

Answer 16

One-sided asymmetric information: When one party knows more than the other party. The party with the superior information should have the decision authority, in order to realize the maximum surplus

Two-sided asymmetric information: When both parties do not have complete information. Exchange in a situation with asymmetric information will occur only when the surplus involved is large enough

Multiple parties: Coase theorem assumes two parties to an exchange. More parties would further complicate exchange when there is asymmetric information