Applied Welfare Economics Part IIB: Paper 1

2. Outline Externalities and the Pareto conditions Dealing with externalities in a first best world without government intervention: the Coase Theorem.

3. What is an externality?

4. Two types of externalities Consumption externality: The choices of some agents (consumers or producers) affect the utility of others. Production externality: The choices of some agents (consumers or producers) affect the profit (or cost) of other producers.

7. Externalities and the First Welfare Theorem A competitive equilibrium is Pareto Efficiency if there is Perfect competition in all markets No externalities (or public goods) Perfect and symmetric information.

8. The Three Pareto Conditions

9. Solving externality problems First best world Coasian medicine: Decentralized bargaining between the affected parties. Pigouvian medicine: Centralized intervention in the form of an externality tax. Second best world Information: Impossible to observe the externality generating activity directly. Distortionary taxes: Interaction within the overall tax system.

10. Regulation of externalities in a first best world Coase versus Pigou

11. Framework Two (types of) consumers, A and B. Two commodities, x1 and x2, and one input, l0 with consumers prices q=(q0,q1,q2) and producer prices p=(p0,p1,p2). Perfect competition and CRS in production. No taxes levied for optimal tax reasons. Observable consumption externality:

12. The Coasian Solution Idea: The inefficiency associated with an externality means that there are gains from trade and the parties affected should be able to come to an accommodation and internalise the externality. Pre-requisite: Property rights to the externality should be defined and should be enforceable by the �courts�. Policy implication: Decentralized solution to externality problem and no need for direct government intervention. Government�s role is limited to that of enforcement.

13. The Coase Theorem If 1) transaction costs are zero (low); 2) property rights are well-specified and enforceable; 3) all parties involved have perfect information about all relevant aspects of the situation, then private bargaining among the parties affected by an externality implements a Pareto efficient allocation.

14. The logic Consider a negative consumption externality A wants to play Hendrix very load; B living next door wants to study in peace. Property rights: College grants B the right to peace. Bargaining protocol: Take-it-or-leave-it offer from B to A consisting of a payment, T, from A to B in exchange for granting permission to play Hendrix at a particular volume.

15. The bargaining solution

17. Problems Well-defined and enforceable property rights Transaction costs Many agents involved => large transaction costs and bargaining become impractical. Legal and monitoring costs Small fixed transaction costs are ok, but large costs exhausts the surplus.

19. Asymmetric information The key problem, typically, is that the benefits and costs are private information: Source has incentive to under-state the benefit Receiver has incentive to over-state cost Implication: The outcome of Coasian bargaining may not be efficient and so externalities are left un-internalized.

20. Bargaining with asymmetric information

22. Information and inefficiency

23. The Coasian Solution?  Not a universal solution, but might work in specific cases where transaction costs are low and information is easy to transmit and verify. In cases with few parties involved allocation of rights and a legal support system may be enough. In cases with many parties involved, this will not be sufficient and direct government intervention must be considered.

24. What is next? The Pigouvian tax solution Externalities in a second best world