Week 8

 Pareto improvement
o Good for everyone
o Makes some people strictly better off, doesn’t make anyone worse
 Kaldor-hicks
o Good for society as a whole
o May make some people worse off, but increases total surplus
 Externalities cause inefficiency
o I’ll do something whenever private benefit > private cost
o Efficiency depends on whether social benefit > social cost
o If I was the only one affected by my choices, then social benefit = private benefit and
social cost = private cost
 When I’m deciding which movie to watch on Netflix, nobody else is affected by
my choice, so my choice will be efficient
 Tragedy of the commons – example

o A. H(100-H) – 12H
o B. h(100-H) – 12h
o A lack of clear property rights can lead to severe inefficiencies
o Coase theorem: in the absence of transactions costs, if property rights are well-defined
and tradable, then voluntary negotiations will lead to efficiency
  It doesn’t matter how rights are allocated initially because if they’re allocated
inefficiently, they can be sold/traded until they’re allocated efficiently
 Bargaining
o Threat point – the payoff I can get on my own, by refusing to cooperate with you (also
called reservation utility or outside option)
o Your car is worth 3000 to you and 4000 to me. Suppose I have 10000
o If I don’t buy the car from you
 My payoff is 10000( my threat point)
 Your payoff is 3000
 Combined payoffs are 13000
o If I buy the car for some price P
 My payoff is 4000 + 10000 –P = 14000 –P
 Your payoff is P
 Combines payoffs are 14000 – P + P = 14000
o 1000 are the gains from trade ( or gains from cooperation)
 No trade – combined payoffs of 13000
 I buy car – combined payoffs of 14000
 If we cooperate, our combined payoffs increase by 1000
o Threat points: 10000 and 3000
o Gains from coop: 1000
o Supposed the gains from coop were split equally
 We’d each get 500 more than the threat point
 If there are transaction costs, voluntary negotiations may not lead to efficiency
 Transaction costs
o Anything that makes it difficult or expensive for two or more parties to achieve a
mutually beneficial trade are transaction costs
o three categories
 search costs – difficulty in finding a trading partner
 bargaining costs – difficulty in reaching an agreement
 enforcement costs – difficulty in enforcing the agreement afterwards
o bargaining costs
 asymmetric information
 private information
 uncertainty
 large number of parties
 no transaction costs/bargaining is easy
o initial allocation of rights doesn’t matter for efficiency, wherever they start, people will
trade until efficiency is achieved