gaus reading
DESCRIPTION
Reading by GausTRANSCRIPT
II
3
Efficiency
OVERVIEW
W e hLvc tlllLs ll txllsed OIl individual Lltionalitv wht is it to
Ill a ratiollal actor and how call we flJrlllally llodcl such 11l
Ictor This ehlptcr begills with that COllClTll but thcll turm to all
how rlliollal actors illterlct-~middotIhl subject of th( ITIIllindcr
of thl book Thl lliaill COIlClf1l of this chapter is to explore the relatioll betwce]] rational actio]] lIld the idea of ctrlcicllcy the
starts With eHlciellcy of the COIISUllIptioll dccisions of olle perSOIl and thell IlHlV~S to the idea of all dhjcnt cxchange all intlllctioll
llttwlcll two (collolllildly ratillnll Igtnts The illiporLllIt ide1gt of l)dYlto slIj1criorily llld Pareto optillalit) an introduced Thl secolld plrt
Df till chapter briefly skltches vlI-knllwll Elilurcs of vlriollS Ilotions of ctlTl1i1itics
31 RATIONALITY AND EFFICIENCY
Everyone knows that cconomics is about diicicllcy and most of us
have SOlllC pro Of COil lttitud about IbM SOIllC of 1I~ Ire all [(JI
while others i1lsist that dlicie1lt) i a cold eUJI1011lic value
that mllst lIot Ollle before tquit) COllcern (H the needy or prortc tiOll of tht envirolllllent Tim it is Iid wc Ileed to trade ott efEcicllCY against othtr ydues I But while most of us kllovv vlhether
we art fe) it or Jgill it we art oftcll Ilot surt what it is Just what
72
I EFFICIENCY
IS trtIC1lllCY I it simply Olll vahlt JIllung othcrs---ollt that tumoshyIllists but not the rest of LIS find vtry attralt(ive-or it is sOl1lehow a tl1ldalllenral idt1 that we callnot do without V hleh we tllllilt not to
sacrificc flJr othtr thillgs~
Efficiency and Rational Individual Choice
Let liS reflcct Oil wlllt wc know Ibout ollr ratiolul ecollolllic 111111
As a Lllionll hooser UOIIIO I(ollolllims lLIS a well-[(JrlllCd utility
fimctioll sltisfying the requirelllents oj urility 1 henr we calllillcd in SectioJli 22 alld 2t His nrdlTellccs 11 haraetlrind
dellland Cllr(S
sI11)titution of goods ill Section
J11110 1coIIlJlllioS Ius 1 prcrlrlllle ttll pin
How Illuch pilla is it rltiOlul fur -101110 hollOlllims to COllSllllll~
Suppose tint the cost oj pinl comtlllt It II() we Illmt rCIllclllhn
that cost wc 111111 the toLl I PIOlllllil) (lsi of C()JlUlllil1g
tl)]golle opportlillitil to satist~ othlr prctl-rcllces ) poillt )) It is 1I11porLmt to stress that cost does lot
Illclsslrilv mcall a mOlletary pIYllIellt or sOllllthing that VOli don I
ill 1 emt oftaklllg this ((Hirst IS that I have to take tct) III
the lCllI10111ists sellse the nl)t ofgttillg your rJ1t choice of1
is thll you hld to ()rgo your ccontl choice of 1 bo of hickell
whcl1 you h1Vl to choose hetweell good things the cost of your (kcision i tht thillg you didnt cIH)osl This cm be
in knns of 1101110 1(oll(lllli(JIs [llrgolll utility-middot-call this It i the utility you would hlve received tiOI11 vour scCtmd
elwin Nov consider Air decisloll to ((mSUllll the first slice of It satisfies hi prd(rllHc [llr pina his utility ftllctioll
We call represellt tim SOIlIC Lltilitv bClldit cdl it
(thH is if the utilitv bendits ar~ grlHer thall or thell it vill he ratiolld tll] hilll to purcha~ the slice of
pizza But hould ht hill oul Olll slice) Well we kllow that since the
cost of nizz is comLlIlt per LlIlit the COit of the second pilcc will he
But htCHISC of decreasing marginal utility the bcnefitlt of the
sltcoml piece will be Ic th111 twill 1(raquo c111 this I(il) + 11(1) III I IS 1 Illlillber less th]]1 11(1))) The cruei1i idcl
hert is that vhltevcr the lItilitv benefits or the tlN pien II(h) I the
of the second will be pOitivl
but slllalkr than thc utility orthc first picce (hence
is what IS melnt bv
73
is hertel vill be ulility
Total Costs
3[i(C)]
2[1 (c)]
Idc)
utility tmnefits
CHAPTER 3
Number 01
FIG U R E 3-1 Efficient Consumption where (b) m middotn
Total Benefits
I(b)
I I (b) + [I (b)
II(b)
It will be rational f()r Air to COllSUllle two slices if the utility benefits of two slices is greater thall or equal to the utility costs or two slices~
+ 111(1)-111 21f1(r)l Because the costs are constant benefits arc decreasillg at S011le point it will be the Glse that
or as ecollomists say Illarginal (utility) benefIts that frolll sOllle slice of pizza will be less thall the marginal (utility)
costs he had to iucur ill order to get thlt slice 111 that else it would be irrationll for Homo h((lllolllims to COIlSUIlIl that additional slice of
because the preferellces he then would be satisf)llng an ranked below the prdlrellces he is fillmiddotgoing Figure 3-1 is a graphic repre sentation of a specific example of this simple choice problelll 011 the
left vertiCll axis we measure HOlllo lrollollliwss total utility costs while Oil the right vertical axis we llIeaSLIre his total utility Figure 3-1 it is rational ftlr Olll (01101111015 to purchase three slices of pizza (but no
Homo Erollolllims will conslIme up to the point whtre 1I1Il~~illill bCll~its eqllal lIIil~~illll (os This is olle definitioll of efllciency 1101110
chooses in this way not because ht values more th1I1 a ratiollal actor seeks to IIIltlximize utility
this decisi()ll is simply required rationality To choose any other
74
r
+ [JI(b)-m]
but the
benefits In
EFFICIENCY
Chicken wings for All
4 I 10
Pi128 lor 2 Betty
o I)
Chicken wings for
FIG U R E 3-2 A Simple Edgeworth Box
would be to choose a lowermiddot of course is the essellce of
over 1
is sil1lply
Pizza for AI
There is thcll a clOSt rebtioll betweell etlicicllcy and ratiollal choice to be ntionll is just to choose ill a WJY tlllt hest satistlls 01lts
as sitllations in
Chapter 4 when rationality and dli(illlcy break Ipart III many of these cases we are 1IIKLTt1II1)lIst what i the truly rational to do
that II1cans that the lIIarlinal glillS lre at least
great as the
Efficiency and Rational Exchange
Let liS 1l10Ve to a two-person case Wl will rLprCSl1lt the ell oice problelll in terms of indiHlrence curves plot olles preferences over bundles ofgoods
rates ofsubstitution between thelll (Sectioll 13 poillt Alf has four slices of pizza ~Ild Betty has eight BulEtlo chicken wings And suppose that they have pretty Illllch the sallie preferences over
which it will be dClTelsing
alld chicken so that their indiftircIIlT curves are the sallle Figure 1-2 gives their indifference llIaps Bettys (solid)
indifference curves start in the lower left Alfs curves COllle down from the upper right SllppOSC that ill this worth Box 2 Alf lI1d Betty arc at Doint PI AII has Illlir slices of plzza
and 110 wings while Betty has
75
CHAPTER 3
1 t is to remelllber that Air is inditterent bctvveell all
combinations of pizza and chicken wings on tht indifflrence curve however he prefers 111 hundles on curve Alf to 111 bundles 011
The dotted arrow cOllling dovn frolll the top right comer shows that as All J1loves southwest he reccivcs incrc)singly prcshy
fiened combin1tions of pizza and chickcll wings If hc moves all the WIY to the southwest comer he receivcs all the pizza and all thc
chickcll wings The solid arrow represcnts the direction that Betty to 1110C startillg at the lowc1 lett corner he prcftrs c01llbishy
lations of chickell wings ald pizza that are to the l1orthclst So is indifltrCIlt lwtwcen all hundlcs of pizz1 and chicken wings on
the indiffercnce curve Betty I hut she prdirs 111 the bUlldk on lktty to any of the hundles Oil Betty I (AmI of course sht is indit1(rlllt
between the hundlls on Iktty2) Now any point III the f()]lllCd the Alfl-LkttYI indittershy
lnee curves improves thl utility of both AIr 1l1d Bettv over point PI allY pOInt ill the eye Illoves cach to a higher indiffercllce ClrVl
Pick allY point ill the cye you will sec that Betty and Alfhlve both
llloved liOI11 PI ill their preflrred dlr~dJollS What this show is that
both em he made better orf hI excilange CI1II t01I11r 11(1 IIddillOIl1i UIlC ICC ((((ed An exchange that moved both Alfand Betty to
poilll p on Figure -2 would Ilnke both of thcm better ofl both In
raised to a higher indifTlT~l1cl curve lote that jgt is Oil
Bcttygt We Clll say thcn that point raquo Oil 1~lguIT 1-2 is
to point Igt I at ]elst olle p~rson is better olLmd 110 Olll is worse olf 111 this case both pcople- arc better olr
But dthough the hlrglill at p is Pareto-superior to PI thcre arc still Pareto-superior bargaills that Alf and Betty can make stlrtJllg at 1gt2 The gains fiom trade have 110t becll exhamtld 0 long as Paretoshysuperior l110ves are 1V1ihhlc AILlIld Bettv can kccp (lll trading and at
least olle will bcnefit Whcn lrc the possihle gains ii-olll trade lxhaustecP We call easily scc tiOI11 Figurl 3-3 til]t when tlly reach 1 hlrgain at which their illdit1lrclKl curves Ire Llllgcnt Paretoshysu perior IlIOVlS arc ex hlllsttd
Consider Il)f exalllple point l At point 1 AII em only lllOVl
ineiitttgt[(IlCt curve if Betty 1l100lS to a lower indifltrcllcl
that would make her worse Jnd a 1110ve
IS on Iv igtlrtto-lll)fr]or if no one is made worst otr So too starting at
vIY th11 lkttv can rise to a highn inditlercllce curve is ifAlf moves to a lower Ollt -that is he IS worse off Point 1 is thus a P1YCfO-Olllilll1 hmlin any departure frol11 point P v would
76
4
Pizza for 2 Betty
deg
8
deg
EFFICI NCY
Chicken wings for
4
4
Chicken wings Betty
FIG U R E 3-3 A Contract Curve
o
P2middot P 1
1deg
Pizza for Alf
lJJ]kc either Alfor Lktty worSt otr Point I therdl)re is etlicient all the gaillS 110111 possible exdLJIlgl have 11lTIl Cxhllisted But
IS Ilot unique in this lcgml ally blrglin that occupics a which AU and Bctty illllitTercllcc curvcs are tl11gcnt i Jgtaretoshy
Thc line A-B (which is called the (Ollimet nrlc) represcnts
Ill slIch possihle etliciellt b]rg)il1S~(lIleS tiIat usc all thc possihle
110111 tLldl ()bviously st)fting tJOI11 point 11gt sOllle or the el11cient
contrlCts Llvor Betty while others llT better for AWl rates of
rationll people Notice two thin~s hlsl the
substitution is lTucid ill trade with c]ch other Because they eKh prellT varied to
hundles ltT(lods if AIr is ninl-rich he will
Betty
77
over
those last two slices 01 [(Hlr chichll wings)
CHAPTER 3 EFFICIENCY
slices of pizzJ Thus as I have depicted the problem it is irratiol1Jl for Alf Jnd Betty to refrain fi-om trading if they keep their bundles at PI they Jre satisfying lower- over higher-ranked preferences
We are now in a position to understand the concept of PJreto or allocative efliciency~ We can say that distribution )) is Parctoshy
slIperor to (more efficient than) I) I if and only if no person is on a lower indifllrence curve ill 1)2 than that person is in [) I and at least one person is on a higher indifference curve in I) than she is in ]) I If despite the possihility of a move to a pJreto-superior distribution we stay in ]) I therc is at least one person who could achieve J higher level of preference satisflction without lowcring anyone elses Thus in Figure 3-3 the distrihution identified by P is Pareto-superior to the distribution of P I As in all the cases we luve discussed thus tlr (but see Section -1-2) there is something irrational ahout maintaining Pareto-inferior distributions In addition to being Pareto-superior to hoth P I and P2 point P is also Pareto-optIIIII just becallse there is no alternative distribution which is Pareto-superior to it That is if Alf and Betty have arrived at P there is no way in which one of them can be raised to a higher indifltTcnce curve without the other l110ving to a lower curve
Is the Pareto Criterion a Moral Ideal
Paretian Welfaristn The Pareto criterion is often IInderstood not simply as J requirement of ratolltllit) qlla cftiCIency but as a standard by which wc cm judge the 101111 desirability of a distribution or in gencraL a social stateS To many it seellls c1car that distribution 1)2 is morally better than D I if (alld only it) somc persons wcltlre is highcr in D and 110 ones is lower than it was in I) I Especially in politics it is thought what is good fllr pcople-their weltlrcshymnst be thc (sole) critcrion ofa good policy This view has clear roots in utilitarian Illoral theory which identified promoting hUl11an hapshypiness as the sole goal of morality and politics Recall the rcmark quoted in Section 11 from Nassau Willial11 Scnior a leading political economist of the ninetcenth century economics he said could aSSUl11e that everyone seeks wealth because wealth and happiness are vcry scldol11 opposed The nltimate aim was clearly human happiness even if the proximate aim of econol11ics was the growth of wealth Now contemporary wclfare ((oIIOI1lrs typically understands a persons weltlre to bc mcasured bv her utilitv function If the utility of Betty is II in ditribution ))1 md 1+n in U 2 then it is aid
her welfare is higher in I) than in I) I and D2 is a better distribution than 1)1 Here however things get complicated The early utilitarshyians such as Jerel11Y Bentham and his followers believed that utility (pleasure) was a cardinal measure (it could be measured along a metric) and that when contcmplating a move from I) I to U we could scnsibly add the utility Alf received from the move fi-om I) I to ))2 to the utility Betty received and then subtract the loss of utility to Charlie (who let us say was better offin I) I) Having done our sums we could then decide whether ovcrall the move from )) I to 1)2
increases overall aggregate utility Bnt we have secn (Section 23) tlLlt there is no particularly good reason to add von Neumann-Morgenshystern cardinal utilities of different people unless there is a special else for some additive function it is simply arbitrJry to SUlll up cardinal ntilities The contcmporary welflrist seems to have a problem how to compare social states without ll1terpersonal complrisons of uti Ii ti es
The Pareto criterion sce11lS to onlr a way out of this problem if no one is worse off in ])2 than she was in ]) I and at least one person is better ofT in ]) than he was in ]) I then ]) is Plrcto-superior to I) I And since the welElre economist has identified a persons welLlre with her utility It looks as if we call say that ))2 does better tr011l the perspective of human welElre Now it is otten thought that this cannot be a very usefiil criterion of moral betterness it oilly yields a judgl11cnt that 1)1 is better than I) I if 10 (Jll is worse off in I )2 But how otten is it the casc tlLlt no one is ll1ade worse ofP On the Parcto test if in ])2 one l11illion people are made better otf thm they were in I) I but one person is worse off we canllot say thlt 1)2 is Paretoshysuperior to I) I Is there ever we might well wonder a Paretoshysuperior 1I10Ve to be made We Ire now in 1 position to see the econol11ists deep attractIOn to market transactions Under certain idealizing conditions (eg full information no third-party ef1ects) each market transaction moves us to a Pareto-superior distribution When people trade they prefer what the other persoll has to what they offer to give lip and so we move to a Pareto-superior lhstribushytion As long as we have not exhausted the possibilities fllr exchange-as long as there are trades that people Wll1t to makeshywe have not exhausted the possibilities ftlr Pareto-superior moves
Althongh market transactions are otten moves to Pareto-superior outco111es it is much harder to see how a collective public policy em meet the Pareto tcst It is hard to think of any uniform policy that does not disadvantage someone(gt To avoid thi~ conclusioll (ie that
78 79
CHAPTER 3
the Pareto critenol must he violated wclbre economist llld Parctiall adopttd what is known t the
llllit(JrllL sOllle
han
dislrilJIIlilll J) 110 OJ is (1ell 111111 SOIlC lose U) IIIOIllIgIOIiI lJ I 10
(IS IllllSC 11110 do lite IlIllle could laquo1111pCIISIle IiiI loSls - To grasp what it l1IellllS to say that a persoll wilid be
t()r a cOllsider AIf~ who wc m is the
sole persoll who has hetLL 11Lilde worse tht 11I0ve tlOI1l Dl to 1)2
make the casc SlllLp1lt asUlI]( that lverYOl1C else is hctter otr ill D21 To say that All ha bccll madc worse 011 llleIIlS that he is Oil a lowcr iLlditllTl1ce curve ill I) thaLl hl was ill I) I Nox iLlLagilll
after the move to I) the trallSterred ellough of their to Alf [() raise hill hlck to thl iLlditl(rcllce curve tint he
this would brillg Ilbout a Ilew distrihutioll 1 ) which is iLldced
to I) I because everyolle etelt All is It II higher indifflTlLlcl curve ill I) thl1l they were ill ))1 Illld Al(i LlOW back
OJl the lIlle inditllilLlCl cUne (as he vIlS ill l) 1 W l CllIl say
thlt 1)2 i Kaldor-Hicks Paretosllperior to 1)1 iftlllrc is a distribution I) that (I) could be L1roduced bv rldistribulilll the 1110Vlllg Iiom I) I to I) alld I) is the llorJlul larlloshy
) and (2) 1lS hcCII
has bl~n
to I) I Note the Kaldor-llicks test SllyS that to I) I (1(1
I )jstrihutioll I) is that ill which
lllade bllt Kaldor-Ilicks docs lIot say silllpl) thlt I) is Plrctoshy
to (more dllcicLltto 1)1 it says thlt I) is
I) 1 evell thollgh SOIllC pcopk the 1110VC llOlll 1)1 to 1)2 Belallsl Iraquo (ltlIld becausc I) 1I(1111d be Pareto -sllperior to I) I
Paleto-sllplTior to I) 1
To lIUllY tIllS S(lIllS
blSCd Oil the dClllld tht vcry odd
fill SOllle ClIIl
illcurrld losses give rise to I) alld I) is Kaldor-I-Jeks
which WlS
IS lOW elllployell to
DtlLers The lllove iolll I) that hellLtit SOllll at the expCIlSl of
to 1)1 lIukes Stlllll peop1lt worse ofl~ yet it IS Iusttlell as a
backdoor way of
alld gil ins within II Paretillll tiullcwork
Kaldor-Hicks looks like a
U)lllplmSlJllS of utilit loss
Even if we put aside the controvlTsilll Iltaldor-Ilicks interpnlltioll
or the Plrlto crittrioll llJOll rdlectioll thl Panto test is l10t as U11COI1middot
troversid as is ofkll thought Much othl lppllll of the Parltu criterion
lies ill the question Who could posltibly object to all improvell1ent that lllakes everYOlll better olP Figure ~f suggests IIll answer
80
r EFFICIENCY
--_93 Bettys
Dgt
o utility
FIG U R E 3-4 A Series of Paretian Moves
wc start at point O and lliake the Plnto-superlOr l1l0Ve to
A which is OIlL possible distributioll alollg l) I the Plrlto
Frolltier the set of possibk Plllto improvemLllts frolll O Ollct WL
are It A tht Pareto impwvcllltllts to I)gt Ilrl liLllitld to thosl lwtwttll
poillts W llld X other thllli ill l) I so are llot Pareto illlproVllllCllts Assume thcll tInt at soml
distributioll 1)2 becolllcs 1 poisibllity Alf llld Bctty makc the
Pareto move to poillt B 011 1)2 Suppose now that ill the ttlture 1)1
becolllcs possibk llO the possible PIlrLto improveLlllms are limited to
thOSl bllillg bctelll Y and Z We em sce that successive applicatiollS
of the Parcto critcrloll Illove distrihwiollS alollg a plth that is incHs
illglv [wlldieill to AlfaLld urless bCllefit to Bctty Ifwc Iud bcell abk to
JUIllP to I) all at Ollce cvcrythillgoll it would be1 Pareto over 0 hut ollce we have llladc the interlllediatc lllOVeS to A IlIld B
lllOSt of 1) is cduded by the Plfeto crlterio]l Perhaps
would havc good rcaSOll to objcct to the illitial Pareto LllOVC to The Pareto prillciple allows a wide rJllgc of movcs llld it Illay matter a
lot which of those is 1Cltllllly made alld ill whlt ordeL
Welfare and Preferences aside thest problems with the
Plrcto criterioll it also SlelllS doubttttl that we should accept the
idciltiticatiuLl of prelerlIlCe SJtlsLlctioll with welflre We llve
cell that prekrlllcls Illld lot be Jbnut olles own good or self
interest anytilllc OllC rallks all outcome above another Olle hilS 1
21) llClll our last-Llllmgo rdtslr frolll Sectioll
is llot to take the List LlllllgO though as Slll llotlS
she would like thJt lllJllgO and would WdCOlllC SOllleOlle thrustillg
81
CHAPTER 3
the mango on her III that case it seel11S doubtful that we should say that her welfare is enhanced by satistying her pnferellce not to take the last mango since her civility preference instructs her not to do what would be good filr her Those who identity wef1re with preference satisfaction often simply seem driven to stipulating that in this case ones wel6re IIIl1sf be advanced because one is what one prefers Here I think is a perfect example of the way that the ambiguity between the techniGlI and ordinary senses of
21) leads to serious confusions Preterellees regarding others also posc f(x Plretian
welfllmiddotis111 Suppose Alf is a prude who ~1 sOllwwhat racy book such as Lady I LeweY It seems tlut
to Paretian wcltJris11I book cannot he approved of by the Pareto vorsc ofT whell she felds the book we might normally think she has right to
illditrerel1ce curve The way in which the Pareto principle call COI1shy
flict with all individuals rights to decide what she is to do has been analyzed All1arty~l Sen) Sen conceives of a person having 1 right as having lllthority to dtcicle the sociJi preference over at le~lst one pair of alterIlJtivts (xy) such that if~l person chooses x gt- l th1t is the social preference us cl11 this social prdlHllce xP)) and if the person chooses ygt- x then yPx (ie the social prellrence is y over x) Sen shows that attributing sllch rights to two persons and asslll11ing all possible of social states are permissible the s(leiJI olltcOl11e selected by the rights can conl1iet with a version of the Pareto
accordillg to which if fOf evcryone xgt- y then xfly That is if everyone prefers x to y then the social preferellce nHlst he x ()vtr y Sen nicely un1111arizes his lrgUll1ent
There is a book (eg Lilly Chatterleys L(1(I) which may be
read hy Mr A (the prude) or Mr B (the bscivious) or neither Given other things thest three alternatives define
social stHes ltI Ii and ) respectively Consider now the following possibility The A most (1 (no one
then l (Ill take the hurt on and lastly ) that lasciviolls lapping it up) The Iasciviol1s
prefers 1110St tl Cit will that lilywhite baby a lllce stwek) then b (it will be fun) and last () (whJt 1 waste of a book) 011 grounds of individual freedom si nee B wan ts to read the book rather than 110 one reading it
82
T
EFFICIENCY
sil1le A does not wallt to read it (l is soudly better than lt But t1 is Plreto-superior to
If)ltl
So we get hfl (by Mr Bs right) oPa (by Mr As md (f Ph Pareto since in both Mr As and Mr Bs lt1gt- b) so wt
gct lJoJgtiI))-m illtDllsitivl result Sell saw this not as a case rights but as showing the unalceptlbility of the 1lIITto universal ruk 11 Sometimes it seems that a cOJ11mitment [0 Pareto
ClIl ICHlllS astrIY lt- )I1C WIY to respolld to this problem is to
exclude sOl11e sorts of prcflrCllClS tjOIll cOllsiderltion thus we restrict Ollr weltlle Paretianislll to ellces over diftlrcllt Stltcs of ones own litc) and so ignore that other people do rather thm not do ccrtlill things not read Llther thlIl rcad ccruin hooks) But this solve all the
over lllany expellSlve OllCS Given thesc structures Pl1Tlian wclt~ms11l approves ofdistriblltiolls tint
r1l~e liS both to hiuhcr indifilrlnCl curves-- livilH llll lxplnih Illd 12 you
Fair and Unfair Starting Points Perhaps the 1llOSt seriolls probkll Pllltil11 wlIElI-isl1l is thlt it is instllsitive to the distributions ti-oll
which we Suppose thlt 111 of Alfs 111d
over quantities ofpiZlt 1l](1 chickcll wings hut and 111 the chickcli wings ami Bltty has nOllto
Pmto principle this is all dlicient distributioll Since Bctty hIS notil ing to t]J(Je thne is no way to nuke her bettll off without lllaklllg AII worse ()f1~ so wc have achieved Pareto optimality 13m this hardly setlllS a moral reason to e111hr1Cc the distribution Thc hl~lrt of the Paretian project is to make pcople hetter ofT and WhCIl no 011( call he made hettcr off without lowering S()llleOIH elses utility the Pareto criterion Ius llothing lllort to say---we hlv( achieved optil1lalitv_ But liol11 the perspective of advmcing 11l1111m Welf~l1T it is hard to
conceive of situ at lOllS where Betty has IlothiIlg lS optind Plausihle versiollS of Parltilll welfllism thus seelll COllllllitted to S0111( idca of1 flir starting point mel flim can hold that Plflto-lpproVld moves l111lk from the illitil t1ir startim poillt arc mOLll
83
(xlcrlulilic All
this impact 1S
bellefit
prodllcns or C(lIlUlIlcrs cost
11IlPOSlS extcrtlliities
I ratiollli ccollomic Igcnt Air
CHAPTER 3
32 EFFICIENCY EXTERNALITIES
AND PUBLIC GOODS
Externalities and Property Rights
to the cHIcielltour f(1ClIS tI0111 tile eltlcicllt
that you ideJ 1IS
our allalysls of all et1iciellt COllSlllllptioll decision you up to tbe point where your marginal bendits
your 111lrglllal costs lfyoll stop producing pizza wilile yuur
your Illanrinal l()sts it looks
pizza how l1lucb beln
benetlts are still greater thall
illsoClr as production of1I1 extr1 t~lCtion th1Il it costs (rlllItmber our concern is opportunity costs) To produce pizza above md the pOlIlt where your
bcnetlts equal yOUI lllarglllal costs 111lIllS thlt your LIst pin cost
you Illore (ill tLTlIlS of prdtTtIHT sltis6ction) than you received ill which again looks to be all irratiol11 decisioll So I ration11
lIllXilllizer will produce up to the point where her lllargilLIl
benetts equal her lIlargi 1111 costs
The nwbklll is that this lIeed not be the dticiellt level of
ClIglgC ill it up to the point were iis Illarginal bCl1dits ll]lIal iis costs
Alf willllot uke accollnt of the (mts to Betty But if AIr lip to tilt Jloillt wltere his IIIlrgilla] cmts lIld 11lnetits are there Irl additiollal cot to Betty it looks IS if the tot11 ()cial costs
(thl cost to All ami of Alls last unit of productioll lxceednl
tlte entire social bcndits This would violate thl Plreto cnterion AI
has Illoved them both to a 11l distributioll (with thl extrl
lInit of pizzl) which bendits Alf at I cost to Betty A sillli1r l11alysis applies to external bCllefits if Illy production 111 bClIdits to you 1S wcll as to Ille then if- I SlOp production whcn lily muginal bCl1dlts
Illy margiml costs fWIlI a socia] Doint of view (which includes
the bcnetits and costs to everyone) the social mamillal bcnefits still excecd socid 111argin11 osts sincl lily
not taken into account the bellefits you receive
84
EFFICIENCY
Extnmlities 1re a chlt-f source of market f~lilure-the ililurc of the market to produce eHicicllt results Oilly if Bltty)iilly illftTIIIlIics all
the costs alld belldts ofber lctiity will slie stop at just the poillt wlllrt
social lIluginai bendils clt]uII social lllnginal costs So too III a trade
IiAII1nd lkttv ftdlv mternalizt the costs lIld [wndts oCtheir trade
Clll Wl SIY lhe trade lllcesltlrilv moves lI) to l Parlto-sllplTior state If
then l1T tlllrdpartv costs extcl1ldiIlCS) AII llId Betty
Iluke trades where the soci1i marginal costs exceed the social
belldits because they do lint take ICCollnt of the costs to Chlrlic if
the
-----------~--~-~
[xlIeiits exist All llId Belly Illay Ilot tLltlC CVCll thollgh the
bendts lXCCld tlte sociallliarglllal costs
market would SCelll~()(IIICC ctticicllt outshy~- ~-s~~-~l~opert l~lgTt~-IllI~hv ~
--j--~- _--_ --------- - _shytCOllOIlIIC Igcllt illcllltliics ((11- dlld Jmcirs r IllS tlllilil) he
obtlillS the full bClldits Illd PIVS the fidl cost of his llllvlty
Consider thl lII kllO1I os ufthe trlgcdy olthe COIIIIIIOIIS such IS tisheris 1 MI1lY lisheries Irolllld till ~orid liT overtished result
illg ill ] deplctioll oftocks No it would IlroJlblv be to the belletit
of fishlr1l1llI Alf to rnlucl his each llext year it If( lIld h1 (IIilIIl lt lt)hlllillillI 111 lite liilre IIIs r(dll(1d rield Ihis ltlir But hl call1lot if lktty lIId CiJlrlic lish IIIYWI
the stocks will still 1)( dlpktn AII will hwc plid I cost but wlil llot
g1111 lhl full bllIdts orbis rcstLlillt COllvl1sciy Betty Illd Charlie do
lIot pay the full costs of their overllshlllg sillce the costs of Ire trallsi(rnd to other tlshermcll slich ]S Alf Thlls the fisherics 11(
lIld the IIl1rgill1I socid costs lxcecd till lI]1rgill11 bell efi tgt
A schellll tklt illllrnliI7ld III costs lIld bendit -~-u-fJ~~-T the probklli Cltllme we hIVl this
IWClllSl p1llperty rights OHT iish in the onI11 Ire (lItticult to
probll1I1
tiollllizl (tlsh tllId to swilll IWlllld I
I-OVlVer thl ide11 of] SystlllI or property rights th]t illtlr1]lhzcs
benciit Ind cols is lIllre1Iizlblc II II less we restnct vhat Ullints IS 11
l~tlrtli1ity Think abollt SUIs case ofMr Prlldes alld Mr laclviouss
abollt rladillg Lad) L11lIIcrlC(S LtlllT If Mr LISliviom extrLilS 1m ngln l1ld rC1ds till hook thnl is all Mr Prude IS 11ll(k or on~ SIIKl Mr Prude prlill tllal 110 olle
rcads it to Mr Lasclviolls rcldillg it Mr LlscivlOliS It] lJlgltivdy
impactcd the utility fUllctiol1 of Mr Prude If people havc prCflrllHes over thell extlrI1alillcs will hl tVtlYhl~
-- - AlfprdlTs tlw people shop at farget tT WI-Mlrt if
so every tLlIlSlctlOI1 at Wal-Mart involves a Ilegtivl
85
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
Total Costs
3[i(C)]
2[1 (c)]
Idc)
utility tmnefits
CHAPTER 3
Number 01
FIG U R E 3-1 Efficient Consumption where (b) m middotn
Total Benefits
I(b)
I I (b) + [I (b)
II(b)
It will be rational f()r Air to COllSUllle two slices if the utility benefits of two slices is greater thall or equal to the utility costs or two slices~
+ 111(1)-111 21f1(r)l Because the costs are constant benefits arc decreasillg at S011le point it will be the Glse that
or as ecollomists say Illarginal (utility) benefIts that frolll sOllle slice of pizza will be less thall the marginal (utility)
costs he had to iucur ill order to get thlt slice 111 that else it would be irrationll for Homo h((lllolllims to COIlSUIlIl that additional slice of
because the preferellces he then would be satisf)llng an ranked below the prdlrellces he is fillmiddotgoing Figure 3-1 is a graphic repre sentation of a specific example of this simple choice problelll 011 the
left vertiCll axis we measure HOlllo lrollollliwss total utility costs while Oil the right vertical axis we llIeaSLIre his total utility Figure 3-1 it is rational ftlr Olll (01101111015 to purchase three slices of pizza (but no
Homo Erollolllims will conslIme up to the point whtre 1I1Il~~illill bCll~its eqllal lIIil~~illll (os This is olle definitioll of efllciency 1101110
chooses in this way not because ht values more th1I1 a ratiollal actor seeks to IIIltlximize utility
this decisi()ll is simply required rationality To choose any other
74
r
+ [JI(b)-m]
but the
benefits In
EFFICIENCY
Chicken wings for All
4 I 10
Pi128 lor 2 Betty
o I)
Chicken wings for
FIG U R E 3-2 A Simple Edgeworth Box
would be to choose a lowermiddot of course is the essellce of
over 1
is sil1lply
Pizza for AI
There is thcll a clOSt rebtioll betweell etlicicllcy and ratiollal choice to be ntionll is just to choose ill a WJY tlllt hest satistlls 01lts
as sitllations in
Chapter 4 when rationality and dli(illlcy break Ipart III many of these cases we are 1IIKLTt1II1)lIst what i the truly rational to do
that II1cans that the lIIarlinal glillS lre at least
great as the
Efficiency and Rational Exchange
Let liS 1l10Ve to a two-person case Wl will rLprCSl1lt the ell oice problelll in terms of indiHlrence curves plot olles preferences over bundles ofgoods
rates ofsubstitution between thelll (Sectioll 13 poillt Alf has four slices of pizza ~Ild Betty has eight BulEtlo chicken wings And suppose that they have pretty Illllch the sallie preferences over
which it will be dClTelsing
alld chicken so that their indiftircIIlT curves are the sallle Figure 1-2 gives their indifference llIaps Bettys (solid)
indifference curves start in the lower left Alfs curves COllle down from the upper right SllppOSC that ill this worth Box 2 Alf lI1d Betty arc at Doint PI AII has Illlir slices of plzza
and 110 wings while Betty has
75
CHAPTER 3
1 t is to remelllber that Air is inditterent bctvveell all
combinations of pizza and chicken wings on tht indifflrence curve however he prefers 111 hundles on curve Alf to 111 bundles 011
The dotted arrow cOllling dovn frolll the top right comer shows that as All J1loves southwest he reccivcs incrc)singly prcshy
fiened combin1tions of pizza and chickcll wings If hc moves all the WIY to the southwest comer he receivcs all the pizza and all thc
chickcll wings The solid arrow represcnts the direction that Betty to 1110C startillg at the lowc1 lett corner he prcftrs c01llbishy
lations of chickell wings ald pizza that are to the l1orthclst So is indifltrCIlt lwtwcen all hundlcs of pizz1 and chicken wings on
the indiffercnce curve Betty I hut she prdirs 111 the bUlldk on lktty to any of the hundles Oil Betty I (AmI of course sht is indit1(rlllt
between the hundlls on Iktty2) Now any point III the f()]lllCd the Alfl-LkttYI indittershy
lnee curves improves thl utility of both AIr 1l1d Bettv over point PI allY pOInt ill the eye Illoves cach to a higher indiffercllce ClrVl
Pick allY point ill the cye you will sec that Betty and Alfhlve both
llloved liOI11 PI ill their preflrred dlr~dJollS What this show is that
both em he made better orf hI excilange CI1II t01I11r 11(1 IIddillOIl1i UIlC ICC ((((ed An exchange that moved both Alfand Betty to
poilll p on Figure -2 would Ilnke both of thcm better ofl both In
raised to a higher indifTlT~l1cl curve lote that jgt is Oil
Bcttygt We Clll say thcn that point raquo Oil 1~lguIT 1-2 is
to point Igt I at ]elst olle p~rson is better olLmd 110 Olll is worse olf 111 this case both pcople- arc better olr
But dthough the hlrglill at p is Pareto-superior to PI thcre arc still Pareto-superior bargaills that Alf and Betty can make stlrtJllg at 1gt2 The gains fiom trade have 110t becll exhamtld 0 long as Paretoshysuperior l110ves are 1V1ihhlc AILlIld Bettv can kccp (lll trading and at
least olle will bcnefit Whcn lrc the possihle gains ii-olll trade lxhaustecP We call easily scc tiOI11 Figurl 3-3 til]t when tlly reach 1 hlrgain at which their illdit1lrclKl curves Ire Llllgcnt Paretoshysu perior IlIOVlS arc ex hlllsttd
Consider Il)f exalllple point l At point 1 AII em only lllOVl
ineiitttgt[(IlCt curve if Betty 1l100lS to a lower indifltrcllcl
that would make her worse Jnd a 1110ve
IS on Iv igtlrtto-lll)fr]or if no one is made worst otr So too starting at
vIY th11 lkttv can rise to a highn inditlercllce curve is ifAlf moves to a lower Ollt -that is he IS worse off Point 1 is thus a P1YCfO-Olllilll1 hmlin any departure frol11 point P v would
76
4
Pizza for 2 Betty
deg
8
deg
EFFICI NCY
Chicken wings for
4
4
Chicken wings Betty
FIG U R E 3-3 A Contract Curve
o
P2middot P 1
1deg
Pizza for Alf
lJJ]kc either Alfor Lktty worSt otr Point I therdl)re is etlicient all the gaillS 110111 possible exdLJIlgl have 11lTIl Cxhllisted But
IS Ilot unique in this lcgml ally blrglin that occupics a which AU and Bctty illllitTercllcc curvcs are tl11gcnt i Jgtaretoshy
Thc line A-B (which is called the (Ollimet nrlc) represcnts
Ill slIch possihle etliciellt b]rg)il1S~(lIleS tiIat usc all thc possihle
110111 tLldl ()bviously st)fting tJOI11 point 11gt sOllle or the el11cient
contrlCts Llvor Betty while others llT better for AWl rates of
rationll people Notice two thin~s hlsl the
substitution is lTucid ill trade with c]ch other Because they eKh prellT varied to
hundles ltT(lods if AIr is ninl-rich he will
Betty
77
over
those last two slices 01 [(Hlr chichll wings)
CHAPTER 3 EFFICIENCY
slices of pizzJ Thus as I have depicted the problem it is irratiol1Jl for Alf Jnd Betty to refrain fi-om trading if they keep their bundles at PI they Jre satisfying lower- over higher-ranked preferences
We are now in a position to understand the concept of PJreto or allocative efliciency~ We can say that distribution )) is Parctoshy
slIperor to (more efficient than) I) I if and only if no person is on a lower indifllrence curve ill 1)2 than that person is in [) I and at least one person is on a higher indifference curve in I) than she is in ]) I If despite the possihility of a move to a pJreto-superior distribution we stay in ]) I therc is at least one person who could achieve J higher level of preference satisflction without lowcring anyone elses Thus in Figure 3-3 the distrihution identified by P is Pareto-superior to the distribution of P I As in all the cases we luve discussed thus tlr (but see Section -1-2) there is something irrational ahout maintaining Pareto-inferior distributions In addition to being Pareto-superior to hoth P I and P2 point P is also Pareto-optIIIII just becallse there is no alternative distribution which is Pareto-superior to it That is if Alf and Betty have arrived at P there is no way in which one of them can be raised to a higher indifltTcnce curve without the other l110ving to a lower curve
Is the Pareto Criterion a Moral Ideal
Paretian Welfaristn The Pareto criterion is often IInderstood not simply as J requirement of ratolltllit) qlla cftiCIency but as a standard by which wc cm judge the 101111 desirability of a distribution or in gencraL a social stateS To many it seellls c1car that distribution 1)2 is morally better than D I if (alld only it) somc persons wcltlre is highcr in D and 110 ones is lower than it was in I) I Especially in politics it is thought what is good fllr pcople-their weltlrcshymnst be thc (sole) critcrion ofa good policy This view has clear roots in utilitarian Illoral theory which identified promoting hUl11an hapshypiness as the sole goal of morality and politics Recall the rcmark quoted in Section 11 from Nassau Willial11 Scnior a leading political economist of the ninetcenth century economics he said could aSSUl11e that everyone seeks wealth because wealth and happiness are vcry scldol11 opposed The nltimate aim was clearly human happiness even if the proximate aim of econol11ics was the growth of wealth Now contemporary wclfare ((oIIOI1lrs typically understands a persons weltlre to bc mcasured bv her utilitv function If the utility of Betty is II in ditribution ))1 md 1+n in U 2 then it is aid
her welfare is higher in I) than in I) I and D2 is a better distribution than 1)1 Here however things get complicated The early utilitarshyians such as Jerel11Y Bentham and his followers believed that utility (pleasure) was a cardinal measure (it could be measured along a metric) and that when contcmplating a move from I) I to U we could scnsibly add the utility Alf received from the move fi-om I) I to ))2 to the utility Betty received and then subtract the loss of utility to Charlie (who let us say was better offin I) I) Having done our sums we could then decide whether ovcrall the move from )) I to 1)2
increases overall aggregate utility Bnt we have secn (Section 23) tlLlt there is no particularly good reason to add von Neumann-Morgenshystern cardinal utilities of different people unless there is a special else for some additive function it is simply arbitrJry to SUlll up cardinal ntilities The contcmporary welflrist seems to have a problem how to compare social states without ll1terpersonal complrisons of uti Ii ti es
The Pareto criterion sce11lS to onlr a way out of this problem if no one is worse off in ])2 than she was in ]) I and at least one person is better ofT in ]) than he was in ]) I then ]) is Plrcto-superior to I) I And since the welElre economist has identified a persons welLlre with her utility It looks as if we call say that ))2 does better tr011l the perspective of human welElre Now it is otten thought that this cannot be a very usefiil criterion of moral betterness it oilly yields a judgl11cnt that 1)1 is better than I) I if 10 (Jll is worse off in I )2 But how otten is it the casc tlLlt no one is ll1ade worse ofP On the Parcto test if in ])2 one l11illion people are made better otf thm they were in I) I but one person is worse off we canllot say thlt 1)2 is Paretoshysuperior to I) I Is there ever we might well wonder a Paretoshysuperior 1I10Ve to be made We Ire now in 1 position to see the econol11ists deep attractIOn to market transactions Under certain idealizing conditions (eg full information no third-party ef1ects) each market transaction moves us to a Pareto-superior distribution When people trade they prefer what the other persoll has to what they offer to give lip and so we move to a Pareto-superior lhstribushytion As long as we have not exhausted the possibilities fllr exchange-as long as there are trades that people Wll1t to makeshywe have not exhausted the possibilities ftlr Pareto-superior moves
Althongh market transactions are otten moves to Pareto-superior outco111es it is much harder to see how a collective public policy em meet the Pareto tcst It is hard to think of any uniform policy that does not disadvantage someone(gt To avoid thi~ conclusioll (ie that
78 79
CHAPTER 3
the Pareto critenol must he violated wclbre economist llld Parctiall adopttd what is known t the
llllit(JrllL sOllle
han
dislrilJIIlilll J) 110 OJ is (1ell 111111 SOIlC lose U) IIIOIllIgIOIiI lJ I 10
(IS IllllSC 11110 do lite IlIllle could laquo1111pCIISIle IiiI loSls - To grasp what it l1IellllS to say that a persoll wilid be
t()r a cOllsider AIf~ who wc m is the
sole persoll who has hetLL 11Lilde worse tht 11I0ve tlOI1l Dl to 1)2
make the casc SlllLp1lt asUlI]( that lverYOl1C else is hctter otr ill D21 To say that All ha bccll madc worse 011 llleIIlS that he is Oil a lowcr iLlditllTl1ce curve ill I) thaLl hl was ill I) I Nox iLlLagilll
after the move to I) the trallSterred ellough of their to Alf [() raise hill hlck to thl iLlditl(rcllce curve tint he
this would brillg Ilbout a Ilew distrihutioll 1 ) which is iLldced
to I) I because everyolle etelt All is It II higher indifflTlLlcl curve ill I) thl1l they were ill ))1 Illld Al(i LlOW back
OJl the lIlle inditllilLlCl cUne (as he vIlS ill l) 1 W l CllIl say
thlt 1)2 i Kaldor-Hicks Paretosllperior to 1)1 iftlllrc is a distribution I) that (I) could be L1roduced bv rldistribulilll the 1110Vlllg Iiom I) I to I) alld I) is the llorJlul larlloshy
) and (2) 1lS hcCII
has bl~n
to I) I Note the Kaldor-llicks test SllyS that to I) I (1(1
I )jstrihutioll I) is that ill which
lllade bllt Kaldor-Ilicks docs lIot say silllpl) thlt I) is Plrctoshy
to (more dllcicLltto 1)1 it says thlt I) is
I) 1 evell thollgh SOIllC pcopk the 1110VC llOlll 1)1 to 1)2 Belallsl Iraquo (ltlIld becausc I) 1I(1111d be Pareto -sllperior to I) I
Paleto-sllplTior to I) 1
To lIUllY tIllS S(lIllS
blSCd Oil the dClllld tht vcry odd
fill SOllle ClIIl
illcurrld losses give rise to I) alld I) is Kaldor-I-Jeks
which WlS
IS lOW elllployell to
DtlLers The lllove iolll I) that hellLtit SOllll at the expCIlSl of
to 1)1 lIukes Stlllll peop1lt worse ofl~ yet it IS Iusttlell as a
backdoor way of
alld gil ins within II Paretillll tiullcwork
Kaldor-Hicks looks like a
U)lllplmSlJllS of utilit loss
Even if we put aside the controvlTsilll Iltaldor-Ilicks interpnlltioll
or the Plrlto crittrioll llJOll rdlectioll thl Panto test is l10t as U11COI1middot
troversid as is ofkll thought Much othl lppllll of the Parltu criterion
lies ill the question Who could posltibly object to all improvell1ent that lllakes everYOlll better olP Figure ~f suggests IIll answer
80
r EFFICIENCY
--_93 Bettys
Dgt
o utility
FIG U R E 3-4 A Series of Paretian Moves
wc start at point O and lliake the Plnto-superlOr l1l0Ve to
A which is OIlL possible distributioll alollg l) I the Plrlto
Frolltier the set of possibk Plllto improvemLllts frolll O Ollct WL
are It A tht Pareto impwvcllltllts to I)gt Ilrl liLllitld to thosl lwtwttll
poillts W llld X other thllli ill l) I so are llot Pareto illlproVllllCllts Assume thcll tInt at soml
distributioll 1)2 becolllcs 1 poisibllity Alf llld Bctty makc the
Pareto move to poillt B 011 1)2 Suppose now that ill the ttlture 1)1
becolllcs possibk llO the possible PIlrLto improveLlllms are limited to
thOSl bllillg bctelll Y and Z We em sce that successive applicatiollS
of the Parcto critcrloll Illove distrihwiollS alollg a plth that is incHs
illglv [wlldieill to AlfaLld urless bCllefit to Bctty Ifwc Iud bcell abk to
JUIllP to I) all at Ollce cvcrythillgoll it would be1 Pareto over 0 hut ollce we have llladc the interlllediatc lllOVeS to A IlIld B
lllOSt of 1) is cduded by the Plfeto crlterio]l Perhaps
would havc good rcaSOll to objcct to the illitial Pareto LllOVC to The Pareto prillciple allows a wide rJllgc of movcs llld it Illay matter a
lot which of those is 1Cltllllly made alld ill whlt ordeL
Welfare and Preferences aside thest problems with the
Plrcto criterioll it also SlelllS doubttttl that we should accept the
idciltiticatiuLl of prelerlIlCe SJtlsLlctioll with welflre We llve
cell that prekrlllcls Illld lot be Jbnut olles own good or self
interest anytilllc OllC rallks all outcome above another Olle hilS 1
21) llClll our last-Llllmgo rdtslr frolll Sectioll
is llot to take the List LlllllgO though as Slll llotlS
she would like thJt lllJllgO and would WdCOlllC SOllleOlle thrustillg
81
CHAPTER 3
the mango on her III that case it seel11S doubtful that we should say that her welfare is enhanced by satistying her pnferellce not to take the last mango since her civility preference instructs her not to do what would be good filr her Those who identity wef1re with preference satisfaction often simply seem driven to stipulating that in this case ones wel6re IIIl1sf be advanced because one is what one prefers Here I think is a perfect example of the way that the ambiguity between the techniGlI and ordinary senses of
21) leads to serious confusions Preterellees regarding others also posc f(x Plretian
welfllmiddotis111 Suppose Alf is a prude who ~1 sOllwwhat racy book such as Lady I LeweY It seems tlut
to Paretian wcltJris11I book cannot he approved of by the Pareto vorsc ofT whell she felds the book we might normally think she has right to
illditrerel1ce curve The way in which the Pareto principle call COI1shy
flict with all individuals rights to decide what she is to do has been analyzed All1arty~l Sen) Sen conceives of a person having 1 right as having lllthority to dtcicle the sociJi preference over at le~lst one pair of alterIlJtivts (xy) such that if~l person chooses x gt- l th1t is the social preference us cl11 this social prdlHllce xP)) and if the person chooses ygt- x then yPx (ie the social prellrence is y over x) Sen shows that attributing sllch rights to two persons and asslll11ing all possible of social states are permissible the s(leiJI olltcOl11e selected by the rights can conl1iet with a version of the Pareto
accordillg to which if fOf evcryone xgt- y then xfly That is if everyone prefers x to y then the social preferellce nHlst he x ()vtr y Sen nicely un1111arizes his lrgUll1ent
There is a book (eg Lilly Chatterleys L(1(I) which may be
read hy Mr A (the prude) or Mr B (the bscivious) or neither Given other things thest three alternatives define
social stHes ltI Ii and ) respectively Consider now the following possibility The A most (1 (no one
then l (Ill take the hurt on and lastly ) that lasciviolls lapping it up) The Iasciviol1s
prefers 1110St tl Cit will that lilywhite baby a lllce stwek) then b (it will be fun) and last () (whJt 1 waste of a book) 011 grounds of individual freedom si nee B wan ts to read the book rather than 110 one reading it
82
T
EFFICIENCY
sil1le A does not wallt to read it (l is soudly better than lt But t1 is Plreto-superior to
If)ltl
So we get hfl (by Mr Bs right) oPa (by Mr As md (f Ph Pareto since in both Mr As and Mr Bs lt1gt- b) so wt
gct lJoJgtiI))-m illtDllsitivl result Sell saw this not as a case rights but as showing the unalceptlbility of the 1lIITto universal ruk 11 Sometimes it seems that a cOJ11mitment [0 Pareto
ClIl ICHlllS astrIY lt- )I1C WIY to respolld to this problem is to
exclude sOl11e sorts of prcflrCllClS tjOIll cOllsiderltion thus we restrict Ollr weltlle Paretianislll to ellces over diftlrcllt Stltcs of ones own litc) and so ignore that other people do rather thm not do ccrtlill things not read Llther thlIl rcad ccruin hooks) But this solve all the
over lllany expellSlve OllCS Given thesc structures Pl1Tlian wclt~ms11l approves ofdistriblltiolls tint
r1l~e liS both to hiuhcr indifilrlnCl curves-- livilH llll lxplnih Illd 12 you
Fair and Unfair Starting Points Perhaps the 1llOSt seriolls probkll Pllltil11 wlIElI-isl1l is thlt it is instllsitive to the distributions ti-oll
which we Suppose thlt 111 of Alfs 111d
over quantities ofpiZlt 1l](1 chickcll wings hut and 111 the chickcli wings ami Bltty has nOllto
Pmto principle this is all dlicient distributioll Since Bctty hIS notil ing to t]J(Je thne is no way to nuke her bettll off without lllaklllg AII worse ()f1~ so wc have achieved Pareto optimality 13m this hardly setlllS a moral reason to e111hr1Cc the distribution Thc hl~lrt of the Paretian project is to make pcople hetter ofT and WhCIl no 011( call he made hettcr off without lowering S()llleOIH elses utility the Pareto criterion Ius llothing lllort to say---we hlv( achieved optil1lalitv_ But liol11 the perspective of advmcing 11l1111m Welf~l1T it is hard to
conceive of situ at lOllS where Betty has IlothiIlg lS optind Plausihle versiollS of Parltilll welfllism thus seelll COllllllitted to S0111( idca of1 flir starting point mel flim can hold that Plflto-lpproVld moves l111lk from the illitil t1ir startim poillt arc mOLll
83
(xlcrlulilic All
this impact 1S
bellefit
prodllcns or C(lIlUlIlcrs cost
11IlPOSlS extcrtlliities
I ratiollli ccollomic Igcnt Air
CHAPTER 3
32 EFFICIENCY EXTERNALITIES
AND PUBLIC GOODS
Externalities and Property Rights
to the cHIcielltour f(1ClIS tI0111 tile eltlcicllt
that you ideJ 1IS
our allalysls of all et1iciellt COllSlllllptioll decision you up to tbe point where your marginal bendits
your 111lrglllal costs lfyoll stop producing pizza wilile yuur
your Illanrinal l()sts it looks
pizza how l1lucb beln
benetlts are still greater thall
illsoClr as production of1I1 extr1 t~lCtion th1Il it costs (rlllItmber our concern is opportunity costs) To produce pizza above md the pOlIlt where your
bcnetlts equal yOUI lllarglllal costs 111lIllS thlt your LIst pin cost
you Illore (ill tLTlIlS of prdtTtIHT sltis6ction) than you received ill which again looks to be all irratiol11 decisioll So I ration11
lIllXilllizer will produce up to the point where her lllargilLIl
benetts equal her lIlargi 1111 costs
The nwbklll is that this lIeed not be the dticiellt level of
ClIglgC ill it up to the point were iis Illarginal bCl1dits ll]lIal iis costs
Alf willllot uke accollnt of the (mts to Betty But if AIr lip to tilt Jloillt wltere his IIIlrgilla] cmts lIld 11lnetits are there Irl additiollal cot to Betty it looks IS if the tot11 ()cial costs
(thl cost to All ami of Alls last unit of productioll lxceednl
tlte entire social bcndits This would violate thl Plreto cnterion AI
has Illoved them both to a 11l distributioll (with thl extrl
lInit of pizzl) which bendits Alf at I cost to Betty A sillli1r l11alysis applies to external bCllefits if Illy production 111 bClIdits to you 1S wcll as to Ille then if- I SlOp production whcn lily muginal bCl1dlts
Illy margiml costs fWIlI a socia] Doint of view (which includes
the bcnetits and costs to everyone) the social mamillal bcnefits still excecd socid 111argin11 osts sincl lily
not taken into account the bellefits you receive
84
EFFICIENCY
Extnmlities 1re a chlt-f source of market f~lilure-the ililurc of the market to produce eHicicllt results Oilly if Bltty)iilly illftTIIIlIics all
the costs alld belldts ofber lctiity will slie stop at just the poillt wlllrt
social lIluginai bendils clt]uII social lllnginal costs So too III a trade
IiAII1nd lkttv ftdlv mternalizt the costs lIld [wndts oCtheir trade
Clll Wl SIY lhe trade lllcesltlrilv moves lI) to l Parlto-sllplTior state If
then l1T tlllrdpartv costs extcl1ldiIlCS) AII llId Betty
Iluke trades where the soci1i marginal costs exceed the social
belldits because they do lint take ICCollnt of the costs to Chlrlic if
the
-----------~--~-~
[xlIeiits exist All llId Belly Illay Ilot tLltlC CVCll thollgh the
bendts lXCCld tlte sociallliarglllal costs
market would SCelll~()(IIICC ctticicllt outshy~- ~-s~~-~l~opert l~lgTt~-IllI~hv ~
--j--~- _--_ --------- - _shytCOllOIlIIC Igcllt illcllltliics ((11- dlld Jmcirs r IllS tlllilil) he
obtlillS the full bClldits Illd PIVS the fidl cost of his llllvlty
Consider thl lII kllO1I os ufthe trlgcdy olthe COIIIIIIOIIS such IS tisheris 1 MI1lY lisheries Irolllld till ~orid liT overtished result
illg ill ] deplctioll oftocks No it would IlroJlblv be to the belletit
of fishlr1l1llI Alf to rnlucl his each llext year it If( lIld h1 (IIilIIl lt lt)hlllillillI 111 lite liilre IIIs r(dll(1d rield Ihis ltlir But hl call1lot if lktty lIId CiJlrlic lish IIIYWI
the stocks will still 1)( dlpktn AII will hwc plid I cost but wlil llot
g1111 lhl full bllIdts orbis rcstLlillt COllvl1sciy Betty Illd Charlie do
lIot pay the full costs of their overllshlllg sillce the costs of Ire trallsi(rnd to other tlshermcll slich ]S Alf Thlls the fisherics 11(
lIld the IIl1rgill1I socid costs lxcecd till lI]1rgill11 bell efi tgt
A schellll tklt illllrnliI7ld III costs lIld bendit -~-u-fJ~~-T the probklli Cltllme we hIVl this
IWClllSl p1llperty rights OHT iish in the onI11 Ire (lItticult to
probll1I1
tiollllizl (tlsh tllId to swilll IWlllld I
I-OVlVer thl ide11 of] SystlllI or property rights th]t illtlr1]lhzcs
benciit Ind cols is lIllre1Iizlblc II II less we restnct vhat Ullints IS 11
l~tlrtli1ity Think abollt SUIs case ofMr Prlldes alld Mr laclviouss
abollt rladillg Lad) L11lIIcrlC(S LtlllT If Mr LISliviom extrLilS 1m ngln l1ld rC1ds till hook thnl is all Mr Prude IS 11ll(k or on~ SIIKl Mr Prude prlill tllal 110 olle
rcads it to Mr Lasclviolls rcldillg it Mr LlscivlOliS It] lJlgltivdy
impactcd the utility fUllctiol1 of Mr Prude If people havc prCflrllHes over thell extlrI1alillcs will hl tVtlYhl~
-- - AlfprdlTs tlw people shop at farget tT WI-Mlrt if
so every tLlIlSlctlOI1 at Wal-Mart involves a Ilegtivl
85
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
CHAPTER 3
1 t is to remelllber that Air is inditterent bctvveell all
combinations of pizza and chicken wings on tht indifflrence curve however he prefers 111 hundles on curve Alf to 111 bundles 011
The dotted arrow cOllling dovn frolll the top right comer shows that as All J1loves southwest he reccivcs incrc)singly prcshy
fiened combin1tions of pizza and chickcll wings If hc moves all the WIY to the southwest comer he receivcs all the pizza and all thc
chickcll wings The solid arrow represcnts the direction that Betty to 1110C startillg at the lowc1 lett corner he prcftrs c01llbishy
lations of chickell wings ald pizza that are to the l1orthclst So is indifltrCIlt lwtwcen all hundlcs of pizz1 and chicken wings on
the indiffercnce curve Betty I hut she prdirs 111 the bUlldk on lktty to any of the hundles Oil Betty I (AmI of course sht is indit1(rlllt
between the hundlls on Iktty2) Now any point III the f()]lllCd the Alfl-LkttYI indittershy
lnee curves improves thl utility of both AIr 1l1d Bettv over point PI allY pOInt ill the eye Illoves cach to a higher indiffercllce ClrVl
Pick allY point ill the cye you will sec that Betty and Alfhlve both
llloved liOI11 PI ill their preflrred dlr~dJollS What this show is that
both em he made better orf hI excilange CI1II t01I11r 11(1 IIddillOIl1i UIlC ICC ((((ed An exchange that moved both Alfand Betty to
poilll p on Figure -2 would Ilnke both of thcm better ofl both In
raised to a higher indifTlT~l1cl curve lote that jgt is Oil
Bcttygt We Clll say thcn that point raquo Oil 1~lguIT 1-2 is
to point Igt I at ]elst olle p~rson is better olLmd 110 Olll is worse olf 111 this case both pcople- arc better olr
But dthough the hlrglill at p is Pareto-superior to PI thcre arc still Pareto-superior bargaills that Alf and Betty can make stlrtJllg at 1gt2 The gains fiom trade have 110t becll exhamtld 0 long as Paretoshysuperior l110ves are 1V1ihhlc AILlIld Bettv can kccp (lll trading and at
least olle will bcnefit Whcn lrc the possihle gains ii-olll trade lxhaustecP We call easily scc tiOI11 Figurl 3-3 til]t when tlly reach 1 hlrgain at which their illdit1lrclKl curves Ire Llllgcnt Paretoshysu perior IlIOVlS arc ex hlllsttd
Consider Il)f exalllple point l At point 1 AII em only lllOVl
ineiitttgt[(IlCt curve if Betty 1l100lS to a lower indifltrcllcl
that would make her worse Jnd a 1110ve
IS on Iv igtlrtto-lll)fr]or if no one is made worst otr So too starting at
vIY th11 lkttv can rise to a highn inditlercllce curve is ifAlf moves to a lower Ollt -that is he IS worse off Point 1 is thus a P1YCfO-Olllilll1 hmlin any departure frol11 point P v would
76
4
Pizza for 2 Betty
deg
8
deg
EFFICI NCY
Chicken wings for
4
4
Chicken wings Betty
FIG U R E 3-3 A Contract Curve
o
P2middot P 1
1deg
Pizza for Alf
lJJ]kc either Alfor Lktty worSt otr Point I therdl)re is etlicient all the gaillS 110111 possible exdLJIlgl have 11lTIl Cxhllisted But
IS Ilot unique in this lcgml ally blrglin that occupics a which AU and Bctty illllitTercllcc curvcs are tl11gcnt i Jgtaretoshy
Thc line A-B (which is called the (Ollimet nrlc) represcnts
Ill slIch possihle etliciellt b]rg)il1S~(lIleS tiIat usc all thc possihle
110111 tLldl ()bviously st)fting tJOI11 point 11gt sOllle or the el11cient
contrlCts Llvor Betty while others llT better for AWl rates of
rationll people Notice two thin~s hlsl the
substitution is lTucid ill trade with c]ch other Because they eKh prellT varied to
hundles ltT(lods if AIr is ninl-rich he will
Betty
77
over
those last two slices 01 [(Hlr chichll wings)
CHAPTER 3 EFFICIENCY
slices of pizzJ Thus as I have depicted the problem it is irratiol1Jl for Alf Jnd Betty to refrain fi-om trading if they keep their bundles at PI they Jre satisfying lower- over higher-ranked preferences
We are now in a position to understand the concept of PJreto or allocative efliciency~ We can say that distribution )) is Parctoshy
slIperor to (more efficient than) I) I if and only if no person is on a lower indifllrence curve ill 1)2 than that person is in [) I and at least one person is on a higher indifference curve in I) than she is in ]) I If despite the possihility of a move to a pJreto-superior distribution we stay in ]) I therc is at least one person who could achieve J higher level of preference satisflction without lowcring anyone elses Thus in Figure 3-3 the distrihution identified by P is Pareto-superior to the distribution of P I As in all the cases we luve discussed thus tlr (but see Section -1-2) there is something irrational ahout maintaining Pareto-inferior distributions In addition to being Pareto-superior to hoth P I and P2 point P is also Pareto-optIIIII just becallse there is no alternative distribution which is Pareto-superior to it That is if Alf and Betty have arrived at P there is no way in which one of them can be raised to a higher indifltTcnce curve without the other l110ving to a lower curve
Is the Pareto Criterion a Moral Ideal
Paretian Welfaristn The Pareto criterion is often IInderstood not simply as J requirement of ratolltllit) qlla cftiCIency but as a standard by which wc cm judge the 101111 desirability of a distribution or in gencraL a social stateS To many it seellls c1car that distribution 1)2 is morally better than D I if (alld only it) somc persons wcltlre is highcr in D and 110 ones is lower than it was in I) I Especially in politics it is thought what is good fllr pcople-their weltlrcshymnst be thc (sole) critcrion ofa good policy This view has clear roots in utilitarian Illoral theory which identified promoting hUl11an hapshypiness as the sole goal of morality and politics Recall the rcmark quoted in Section 11 from Nassau Willial11 Scnior a leading political economist of the ninetcenth century economics he said could aSSUl11e that everyone seeks wealth because wealth and happiness are vcry scldol11 opposed The nltimate aim was clearly human happiness even if the proximate aim of econol11ics was the growth of wealth Now contemporary wclfare ((oIIOI1lrs typically understands a persons weltlre to bc mcasured bv her utilitv function If the utility of Betty is II in ditribution ))1 md 1+n in U 2 then it is aid
her welfare is higher in I) than in I) I and D2 is a better distribution than 1)1 Here however things get complicated The early utilitarshyians such as Jerel11Y Bentham and his followers believed that utility (pleasure) was a cardinal measure (it could be measured along a metric) and that when contcmplating a move from I) I to U we could scnsibly add the utility Alf received from the move fi-om I) I to ))2 to the utility Betty received and then subtract the loss of utility to Charlie (who let us say was better offin I) I) Having done our sums we could then decide whether ovcrall the move from )) I to 1)2
increases overall aggregate utility Bnt we have secn (Section 23) tlLlt there is no particularly good reason to add von Neumann-Morgenshystern cardinal utilities of different people unless there is a special else for some additive function it is simply arbitrJry to SUlll up cardinal ntilities The contcmporary welflrist seems to have a problem how to compare social states without ll1terpersonal complrisons of uti Ii ti es
The Pareto criterion sce11lS to onlr a way out of this problem if no one is worse off in ])2 than she was in ]) I and at least one person is better ofT in ]) than he was in ]) I then ]) is Plrcto-superior to I) I And since the welElre economist has identified a persons welLlre with her utility It looks as if we call say that ))2 does better tr011l the perspective of human welElre Now it is otten thought that this cannot be a very usefiil criterion of moral betterness it oilly yields a judgl11cnt that 1)1 is better than I) I if 10 (Jll is worse off in I )2 But how otten is it the casc tlLlt no one is ll1ade worse ofP On the Parcto test if in ])2 one l11illion people are made better otf thm they were in I) I but one person is worse off we canllot say thlt 1)2 is Paretoshysuperior to I) I Is there ever we might well wonder a Paretoshysuperior 1I10Ve to be made We Ire now in 1 position to see the econol11ists deep attractIOn to market transactions Under certain idealizing conditions (eg full information no third-party ef1ects) each market transaction moves us to a Pareto-superior distribution When people trade they prefer what the other persoll has to what they offer to give lip and so we move to a Pareto-superior lhstribushytion As long as we have not exhausted the possibilities fllr exchange-as long as there are trades that people Wll1t to makeshywe have not exhausted the possibilities ftlr Pareto-superior moves
Althongh market transactions are otten moves to Pareto-superior outco111es it is much harder to see how a collective public policy em meet the Pareto tcst It is hard to think of any uniform policy that does not disadvantage someone(gt To avoid thi~ conclusioll (ie that
78 79
CHAPTER 3
the Pareto critenol must he violated wclbre economist llld Parctiall adopttd what is known t the
llllit(JrllL sOllle
han
dislrilJIIlilll J) 110 OJ is (1ell 111111 SOIlC lose U) IIIOIllIgIOIiI lJ I 10
(IS IllllSC 11110 do lite IlIllle could laquo1111pCIISIle IiiI loSls - To grasp what it l1IellllS to say that a persoll wilid be
t()r a cOllsider AIf~ who wc m is the
sole persoll who has hetLL 11Lilde worse tht 11I0ve tlOI1l Dl to 1)2
make the casc SlllLp1lt asUlI]( that lverYOl1C else is hctter otr ill D21 To say that All ha bccll madc worse 011 llleIIlS that he is Oil a lowcr iLlditllTl1ce curve ill I) thaLl hl was ill I) I Nox iLlLagilll
after the move to I) the trallSterred ellough of their to Alf [() raise hill hlck to thl iLlditl(rcllce curve tint he
this would brillg Ilbout a Ilew distrihutioll 1 ) which is iLldced
to I) I because everyolle etelt All is It II higher indifflTlLlcl curve ill I) thl1l they were ill ))1 Illld Al(i LlOW back
OJl the lIlle inditllilLlCl cUne (as he vIlS ill l) 1 W l CllIl say
thlt 1)2 i Kaldor-Hicks Paretosllperior to 1)1 iftlllrc is a distribution I) that (I) could be L1roduced bv rldistribulilll the 1110Vlllg Iiom I) I to I) alld I) is the llorJlul larlloshy
) and (2) 1lS hcCII
has bl~n
to I) I Note the Kaldor-llicks test SllyS that to I) I (1(1
I )jstrihutioll I) is that ill which
lllade bllt Kaldor-Ilicks docs lIot say silllpl) thlt I) is Plrctoshy
to (more dllcicLltto 1)1 it says thlt I) is
I) 1 evell thollgh SOIllC pcopk the 1110VC llOlll 1)1 to 1)2 Belallsl Iraquo (ltlIld becausc I) 1I(1111d be Pareto -sllperior to I) I
Paleto-sllplTior to I) 1
To lIUllY tIllS S(lIllS
blSCd Oil the dClllld tht vcry odd
fill SOllle ClIIl
illcurrld losses give rise to I) alld I) is Kaldor-I-Jeks
which WlS
IS lOW elllployell to
DtlLers The lllove iolll I) that hellLtit SOllll at the expCIlSl of
to 1)1 lIukes Stlllll peop1lt worse ofl~ yet it IS Iusttlell as a
backdoor way of
alld gil ins within II Paretillll tiullcwork
Kaldor-Hicks looks like a
U)lllplmSlJllS of utilit loss
Even if we put aside the controvlTsilll Iltaldor-Ilicks interpnlltioll
or the Plrlto crittrioll llJOll rdlectioll thl Panto test is l10t as U11COI1middot
troversid as is ofkll thought Much othl lppllll of the Parltu criterion
lies ill the question Who could posltibly object to all improvell1ent that lllakes everYOlll better olP Figure ~f suggests IIll answer
80
r EFFICIENCY
--_93 Bettys
Dgt
o utility
FIG U R E 3-4 A Series of Paretian Moves
wc start at point O and lliake the Plnto-superlOr l1l0Ve to
A which is OIlL possible distributioll alollg l) I the Plrlto
Frolltier the set of possibk Plllto improvemLllts frolll O Ollct WL
are It A tht Pareto impwvcllltllts to I)gt Ilrl liLllitld to thosl lwtwttll
poillts W llld X other thllli ill l) I so are llot Pareto illlproVllllCllts Assume thcll tInt at soml
distributioll 1)2 becolllcs 1 poisibllity Alf llld Bctty makc the
Pareto move to poillt B 011 1)2 Suppose now that ill the ttlture 1)1
becolllcs possibk llO the possible PIlrLto improveLlllms are limited to
thOSl bllillg bctelll Y and Z We em sce that successive applicatiollS
of the Parcto critcrloll Illove distrihwiollS alollg a plth that is incHs
illglv [wlldieill to AlfaLld urless bCllefit to Bctty Ifwc Iud bcell abk to
JUIllP to I) all at Ollce cvcrythillgoll it would be1 Pareto over 0 hut ollce we have llladc the interlllediatc lllOVeS to A IlIld B
lllOSt of 1) is cduded by the Plfeto crlterio]l Perhaps
would havc good rcaSOll to objcct to the illitial Pareto LllOVC to The Pareto prillciple allows a wide rJllgc of movcs llld it Illay matter a
lot which of those is 1Cltllllly made alld ill whlt ordeL
Welfare and Preferences aside thest problems with the
Plrcto criterioll it also SlelllS doubttttl that we should accept the
idciltiticatiuLl of prelerlIlCe SJtlsLlctioll with welflre We llve
cell that prekrlllcls Illld lot be Jbnut olles own good or self
interest anytilllc OllC rallks all outcome above another Olle hilS 1
21) llClll our last-Llllmgo rdtslr frolll Sectioll
is llot to take the List LlllllgO though as Slll llotlS
she would like thJt lllJllgO and would WdCOlllC SOllleOlle thrustillg
81
CHAPTER 3
the mango on her III that case it seel11S doubtful that we should say that her welfare is enhanced by satistying her pnferellce not to take the last mango since her civility preference instructs her not to do what would be good filr her Those who identity wef1re with preference satisfaction often simply seem driven to stipulating that in this case ones wel6re IIIl1sf be advanced because one is what one prefers Here I think is a perfect example of the way that the ambiguity between the techniGlI and ordinary senses of
21) leads to serious confusions Preterellees regarding others also posc f(x Plretian
welfllmiddotis111 Suppose Alf is a prude who ~1 sOllwwhat racy book such as Lady I LeweY It seems tlut
to Paretian wcltJris11I book cannot he approved of by the Pareto vorsc ofT whell she felds the book we might normally think she has right to
illditrerel1ce curve The way in which the Pareto principle call COI1shy
flict with all individuals rights to decide what she is to do has been analyzed All1arty~l Sen) Sen conceives of a person having 1 right as having lllthority to dtcicle the sociJi preference over at le~lst one pair of alterIlJtivts (xy) such that if~l person chooses x gt- l th1t is the social preference us cl11 this social prdlHllce xP)) and if the person chooses ygt- x then yPx (ie the social prellrence is y over x) Sen shows that attributing sllch rights to two persons and asslll11ing all possible of social states are permissible the s(leiJI olltcOl11e selected by the rights can conl1iet with a version of the Pareto
accordillg to which if fOf evcryone xgt- y then xfly That is if everyone prefers x to y then the social preferellce nHlst he x ()vtr y Sen nicely un1111arizes his lrgUll1ent
There is a book (eg Lilly Chatterleys L(1(I) which may be
read hy Mr A (the prude) or Mr B (the bscivious) or neither Given other things thest three alternatives define
social stHes ltI Ii and ) respectively Consider now the following possibility The A most (1 (no one
then l (Ill take the hurt on and lastly ) that lasciviolls lapping it up) The Iasciviol1s
prefers 1110St tl Cit will that lilywhite baby a lllce stwek) then b (it will be fun) and last () (whJt 1 waste of a book) 011 grounds of individual freedom si nee B wan ts to read the book rather than 110 one reading it
82
T
EFFICIENCY
sil1le A does not wallt to read it (l is soudly better than lt But t1 is Plreto-superior to
If)ltl
So we get hfl (by Mr Bs right) oPa (by Mr As md (f Ph Pareto since in both Mr As and Mr Bs lt1gt- b) so wt
gct lJoJgtiI))-m illtDllsitivl result Sell saw this not as a case rights but as showing the unalceptlbility of the 1lIITto universal ruk 11 Sometimes it seems that a cOJ11mitment [0 Pareto
ClIl ICHlllS astrIY lt- )I1C WIY to respolld to this problem is to
exclude sOl11e sorts of prcflrCllClS tjOIll cOllsiderltion thus we restrict Ollr weltlle Paretianislll to ellces over diftlrcllt Stltcs of ones own litc) and so ignore that other people do rather thm not do ccrtlill things not read Llther thlIl rcad ccruin hooks) But this solve all the
over lllany expellSlve OllCS Given thesc structures Pl1Tlian wclt~ms11l approves ofdistriblltiolls tint
r1l~e liS both to hiuhcr indifilrlnCl curves-- livilH llll lxplnih Illd 12 you
Fair and Unfair Starting Points Perhaps the 1llOSt seriolls probkll Pllltil11 wlIElI-isl1l is thlt it is instllsitive to the distributions ti-oll
which we Suppose thlt 111 of Alfs 111d
over quantities ofpiZlt 1l](1 chickcll wings hut and 111 the chickcli wings ami Bltty has nOllto
Pmto principle this is all dlicient distributioll Since Bctty hIS notil ing to t]J(Je thne is no way to nuke her bettll off without lllaklllg AII worse ()f1~ so wc have achieved Pareto optimality 13m this hardly setlllS a moral reason to e111hr1Cc the distribution Thc hl~lrt of the Paretian project is to make pcople hetter ofT and WhCIl no 011( call he made hettcr off without lowering S()llleOIH elses utility the Pareto criterion Ius llothing lllort to say---we hlv( achieved optil1lalitv_ But liol11 the perspective of advmcing 11l1111m Welf~l1T it is hard to
conceive of situ at lOllS where Betty has IlothiIlg lS optind Plausihle versiollS of Parltilll welfllism thus seelll COllllllitted to S0111( idca of1 flir starting point mel flim can hold that Plflto-lpproVld moves l111lk from the illitil t1ir startim poillt arc mOLll
83
(xlcrlulilic All
this impact 1S
bellefit
prodllcns or C(lIlUlIlcrs cost
11IlPOSlS extcrtlliities
I ratiollli ccollomic Igcnt Air
CHAPTER 3
32 EFFICIENCY EXTERNALITIES
AND PUBLIC GOODS
Externalities and Property Rights
to the cHIcielltour f(1ClIS tI0111 tile eltlcicllt
that you ideJ 1IS
our allalysls of all et1iciellt COllSlllllptioll decision you up to tbe point where your marginal bendits
your 111lrglllal costs lfyoll stop producing pizza wilile yuur
your Illanrinal l()sts it looks
pizza how l1lucb beln
benetlts are still greater thall
illsoClr as production of1I1 extr1 t~lCtion th1Il it costs (rlllItmber our concern is opportunity costs) To produce pizza above md the pOlIlt where your
bcnetlts equal yOUI lllarglllal costs 111lIllS thlt your LIst pin cost
you Illore (ill tLTlIlS of prdtTtIHT sltis6ction) than you received ill which again looks to be all irratiol11 decisioll So I ration11
lIllXilllizer will produce up to the point where her lllargilLIl
benetts equal her lIlargi 1111 costs
The nwbklll is that this lIeed not be the dticiellt level of
ClIglgC ill it up to the point were iis Illarginal bCl1dits ll]lIal iis costs
Alf willllot uke accollnt of the (mts to Betty But if AIr lip to tilt Jloillt wltere his IIIlrgilla] cmts lIld 11lnetits are there Irl additiollal cot to Betty it looks IS if the tot11 ()cial costs
(thl cost to All ami of Alls last unit of productioll lxceednl
tlte entire social bcndits This would violate thl Plreto cnterion AI
has Illoved them both to a 11l distributioll (with thl extrl
lInit of pizzl) which bendits Alf at I cost to Betty A sillli1r l11alysis applies to external bCllefits if Illy production 111 bClIdits to you 1S wcll as to Ille then if- I SlOp production whcn lily muginal bCl1dlts
Illy margiml costs fWIlI a socia] Doint of view (which includes
the bcnetits and costs to everyone) the social mamillal bcnefits still excecd socid 111argin11 osts sincl lily
not taken into account the bellefits you receive
84
EFFICIENCY
Extnmlities 1re a chlt-f source of market f~lilure-the ililurc of the market to produce eHicicllt results Oilly if Bltty)iilly illftTIIIlIics all
the costs alld belldts ofber lctiity will slie stop at just the poillt wlllrt
social lIluginai bendils clt]uII social lllnginal costs So too III a trade
IiAII1nd lkttv ftdlv mternalizt the costs lIld [wndts oCtheir trade
Clll Wl SIY lhe trade lllcesltlrilv moves lI) to l Parlto-sllplTior state If
then l1T tlllrdpartv costs extcl1ldiIlCS) AII llId Betty
Iluke trades where the soci1i marginal costs exceed the social
belldits because they do lint take ICCollnt of the costs to Chlrlic if
the
-----------~--~-~
[xlIeiits exist All llId Belly Illay Ilot tLltlC CVCll thollgh the
bendts lXCCld tlte sociallliarglllal costs
market would SCelll~()(IIICC ctticicllt outshy~- ~-s~~-~l~opert l~lgTt~-IllI~hv ~
--j--~- _--_ --------- - _shytCOllOIlIIC Igcllt illcllltliics ((11- dlld Jmcirs r IllS tlllilil) he
obtlillS the full bClldits Illd PIVS the fidl cost of his llllvlty
Consider thl lII kllO1I os ufthe trlgcdy olthe COIIIIIIOIIS such IS tisheris 1 MI1lY lisheries Irolllld till ~orid liT overtished result
illg ill ] deplctioll oftocks No it would IlroJlblv be to the belletit
of fishlr1l1llI Alf to rnlucl his each llext year it If( lIld h1 (IIilIIl lt lt)hlllillillI 111 lite liilre IIIs r(dll(1d rield Ihis ltlir But hl call1lot if lktty lIId CiJlrlic lish IIIYWI
the stocks will still 1)( dlpktn AII will hwc plid I cost but wlil llot
g1111 lhl full bllIdts orbis rcstLlillt COllvl1sciy Betty Illd Charlie do
lIot pay the full costs of their overllshlllg sillce the costs of Ire trallsi(rnd to other tlshermcll slich ]S Alf Thlls the fisherics 11(
lIld the IIl1rgill1I socid costs lxcecd till lI]1rgill11 bell efi tgt
A schellll tklt illllrnliI7ld III costs lIld bendit -~-u-fJ~~-T the probklli Cltllme we hIVl this
IWClllSl p1llperty rights OHT iish in the onI11 Ire (lItticult to
probll1I1
tiollllizl (tlsh tllId to swilll IWlllld I
I-OVlVer thl ide11 of] SystlllI or property rights th]t illtlr1]lhzcs
benciit Ind cols is lIllre1Iizlblc II II less we restnct vhat Ullints IS 11
l~tlrtli1ity Think abollt SUIs case ofMr Prlldes alld Mr laclviouss
abollt rladillg Lad) L11lIIcrlC(S LtlllT If Mr LISliviom extrLilS 1m ngln l1ld rC1ds till hook thnl is all Mr Prude IS 11ll(k or on~ SIIKl Mr Prude prlill tllal 110 olle
rcads it to Mr Lasclviolls rcldillg it Mr LlscivlOliS It] lJlgltivdy
impactcd the utility fUllctiol1 of Mr Prude If people havc prCflrllHes over thell extlrI1alillcs will hl tVtlYhl~
-- - AlfprdlTs tlw people shop at farget tT WI-Mlrt if
so every tLlIlSlctlOI1 at Wal-Mart involves a Ilegtivl
85
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
CHAPTER 3 EFFICIENCY
slices of pizzJ Thus as I have depicted the problem it is irratiol1Jl for Alf Jnd Betty to refrain fi-om trading if they keep their bundles at PI they Jre satisfying lower- over higher-ranked preferences
We are now in a position to understand the concept of PJreto or allocative efliciency~ We can say that distribution )) is Parctoshy
slIperor to (more efficient than) I) I if and only if no person is on a lower indifllrence curve ill 1)2 than that person is in [) I and at least one person is on a higher indifference curve in I) than she is in ]) I If despite the possihility of a move to a pJreto-superior distribution we stay in ]) I therc is at least one person who could achieve J higher level of preference satisflction without lowcring anyone elses Thus in Figure 3-3 the distrihution identified by P is Pareto-superior to the distribution of P I As in all the cases we luve discussed thus tlr (but see Section -1-2) there is something irrational ahout maintaining Pareto-inferior distributions In addition to being Pareto-superior to hoth P I and P2 point P is also Pareto-optIIIII just becallse there is no alternative distribution which is Pareto-superior to it That is if Alf and Betty have arrived at P there is no way in which one of them can be raised to a higher indifltTcnce curve without the other l110ving to a lower curve
Is the Pareto Criterion a Moral Ideal
Paretian Welfaristn The Pareto criterion is often IInderstood not simply as J requirement of ratolltllit) qlla cftiCIency but as a standard by which wc cm judge the 101111 desirability of a distribution or in gencraL a social stateS To many it seellls c1car that distribution 1)2 is morally better than D I if (alld only it) somc persons wcltlre is highcr in D and 110 ones is lower than it was in I) I Especially in politics it is thought what is good fllr pcople-their weltlrcshymnst be thc (sole) critcrion ofa good policy This view has clear roots in utilitarian Illoral theory which identified promoting hUl11an hapshypiness as the sole goal of morality and politics Recall the rcmark quoted in Section 11 from Nassau Willial11 Scnior a leading political economist of the ninetcenth century economics he said could aSSUl11e that everyone seeks wealth because wealth and happiness are vcry scldol11 opposed The nltimate aim was clearly human happiness even if the proximate aim of econol11ics was the growth of wealth Now contemporary wclfare ((oIIOI1lrs typically understands a persons weltlre to bc mcasured bv her utilitv function If the utility of Betty is II in ditribution ))1 md 1+n in U 2 then it is aid
her welfare is higher in I) than in I) I and D2 is a better distribution than 1)1 Here however things get complicated The early utilitarshyians such as Jerel11Y Bentham and his followers believed that utility (pleasure) was a cardinal measure (it could be measured along a metric) and that when contcmplating a move from I) I to U we could scnsibly add the utility Alf received from the move fi-om I) I to ))2 to the utility Betty received and then subtract the loss of utility to Charlie (who let us say was better offin I) I) Having done our sums we could then decide whether ovcrall the move from )) I to 1)2
increases overall aggregate utility Bnt we have secn (Section 23) tlLlt there is no particularly good reason to add von Neumann-Morgenshystern cardinal utilities of different people unless there is a special else for some additive function it is simply arbitrJry to SUlll up cardinal ntilities The contcmporary welflrist seems to have a problem how to compare social states without ll1terpersonal complrisons of uti Ii ti es
The Pareto criterion sce11lS to onlr a way out of this problem if no one is worse off in ])2 than she was in ]) I and at least one person is better ofT in ]) than he was in ]) I then ]) is Plrcto-superior to I) I And since the welElre economist has identified a persons welLlre with her utility It looks as if we call say that ))2 does better tr011l the perspective of human welElre Now it is otten thought that this cannot be a very usefiil criterion of moral betterness it oilly yields a judgl11cnt that 1)1 is better than I) I if 10 (Jll is worse off in I )2 But how otten is it the casc tlLlt no one is ll1ade worse ofP On the Parcto test if in ])2 one l11illion people are made better otf thm they were in I) I but one person is worse off we canllot say thlt 1)2 is Paretoshysuperior to I) I Is there ever we might well wonder a Paretoshysuperior 1I10Ve to be made We Ire now in 1 position to see the econol11ists deep attractIOn to market transactions Under certain idealizing conditions (eg full information no third-party ef1ects) each market transaction moves us to a Pareto-superior distribution When people trade they prefer what the other persoll has to what they offer to give lip and so we move to a Pareto-superior lhstribushytion As long as we have not exhausted the possibilities fllr exchange-as long as there are trades that people Wll1t to makeshywe have not exhausted the possibilities ftlr Pareto-superior moves
Althongh market transactions are otten moves to Pareto-superior outco111es it is much harder to see how a collective public policy em meet the Pareto tcst It is hard to think of any uniform policy that does not disadvantage someone(gt To avoid thi~ conclusioll (ie that
78 79
CHAPTER 3
the Pareto critenol must he violated wclbre economist llld Parctiall adopttd what is known t the
llllit(JrllL sOllle
han
dislrilJIIlilll J) 110 OJ is (1ell 111111 SOIlC lose U) IIIOIllIgIOIiI lJ I 10
(IS IllllSC 11110 do lite IlIllle could laquo1111pCIISIle IiiI loSls - To grasp what it l1IellllS to say that a persoll wilid be
t()r a cOllsider AIf~ who wc m is the
sole persoll who has hetLL 11Lilde worse tht 11I0ve tlOI1l Dl to 1)2
make the casc SlllLp1lt asUlI]( that lverYOl1C else is hctter otr ill D21 To say that All ha bccll madc worse 011 llleIIlS that he is Oil a lowcr iLlditllTl1ce curve ill I) thaLl hl was ill I) I Nox iLlLagilll
after the move to I) the trallSterred ellough of their to Alf [() raise hill hlck to thl iLlditl(rcllce curve tint he
this would brillg Ilbout a Ilew distrihutioll 1 ) which is iLldced
to I) I because everyolle etelt All is It II higher indifflTlLlcl curve ill I) thl1l they were ill ))1 Illld Al(i LlOW back
OJl the lIlle inditllilLlCl cUne (as he vIlS ill l) 1 W l CllIl say
thlt 1)2 i Kaldor-Hicks Paretosllperior to 1)1 iftlllrc is a distribution I) that (I) could be L1roduced bv rldistribulilll the 1110Vlllg Iiom I) I to I) alld I) is the llorJlul larlloshy
) and (2) 1lS hcCII
has bl~n
to I) I Note the Kaldor-llicks test SllyS that to I) I (1(1
I )jstrihutioll I) is that ill which
lllade bllt Kaldor-Ilicks docs lIot say silllpl) thlt I) is Plrctoshy
to (more dllcicLltto 1)1 it says thlt I) is
I) 1 evell thollgh SOIllC pcopk the 1110VC llOlll 1)1 to 1)2 Belallsl Iraquo (ltlIld becausc I) 1I(1111d be Pareto -sllperior to I) I
Paleto-sllplTior to I) 1
To lIUllY tIllS S(lIllS
blSCd Oil the dClllld tht vcry odd
fill SOllle ClIIl
illcurrld losses give rise to I) alld I) is Kaldor-I-Jeks
which WlS
IS lOW elllployell to
DtlLers The lllove iolll I) that hellLtit SOllll at the expCIlSl of
to 1)1 lIukes Stlllll peop1lt worse ofl~ yet it IS Iusttlell as a
backdoor way of
alld gil ins within II Paretillll tiullcwork
Kaldor-Hicks looks like a
U)lllplmSlJllS of utilit loss
Even if we put aside the controvlTsilll Iltaldor-Ilicks interpnlltioll
or the Plrlto crittrioll llJOll rdlectioll thl Panto test is l10t as U11COI1middot
troversid as is ofkll thought Much othl lppllll of the Parltu criterion
lies ill the question Who could posltibly object to all improvell1ent that lllakes everYOlll better olP Figure ~f suggests IIll answer
80
r EFFICIENCY
--_93 Bettys
Dgt
o utility
FIG U R E 3-4 A Series of Paretian Moves
wc start at point O and lliake the Plnto-superlOr l1l0Ve to
A which is OIlL possible distributioll alollg l) I the Plrlto
Frolltier the set of possibk Plllto improvemLllts frolll O Ollct WL
are It A tht Pareto impwvcllltllts to I)gt Ilrl liLllitld to thosl lwtwttll
poillts W llld X other thllli ill l) I so are llot Pareto illlproVllllCllts Assume thcll tInt at soml
distributioll 1)2 becolllcs 1 poisibllity Alf llld Bctty makc the
Pareto move to poillt B 011 1)2 Suppose now that ill the ttlture 1)1
becolllcs possibk llO the possible PIlrLto improveLlllms are limited to
thOSl bllillg bctelll Y and Z We em sce that successive applicatiollS
of the Parcto critcrloll Illove distrihwiollS alollg a plth that is incHs
illglv [wlldieill to AlfaLld urless bCllefit to Bctty Ifwc Iud bcell abk to
JUIllP to I) all at Ollce cvcrythillgoll it would be1 Pareto over 0 hut ollce we have llladc the interlllediatc lllOVeS to A IlIld B
lllOSt of 1) is cduded by the Plfeto crlterio]l Perhaps
would havc good rcaSOll to objcct to the illitial Pareto LllOVC to The Pareto prillciple allows a wide rJllgc of movcs llld it Illay matter a
lot which of those is 1Cltllllly made alld ill whlt ordeL
Welfare and Preferences aside thest problems with the
Plrcto criterioll it also SlelllS doubttttl that we should accept the
idciltiticatiuLl of prelerlIlCe SJtlsLlctioll with welflre We llve
cell that prekrlllcls Illld lot be Jbnut olles own good or self
interest anytilllc OllC rallks all outcome above another Olle hilS 1
21) llClll our last-Llllmgo rdtslr frolll Sectioll
is llot to take the List LlllllgO though as Slll llotlS
she would like thJt lllJllgO and would WdCOlllC SOllleOlle thrustillg
81
CHAPTER 3
the mango on her III that case it seel11S doubtful that we should say that her welfare is enhanced by satistying her pnferellce not to take the last mango since her civility preference instructs her not to do what would be good filr her Those who identity wef1re with preference satisfaction often simply seem driven to stipulating that in this case ones wel6re IIIl1sf be advanced because one is what one prefers Here I think is a perfect example of the way that the ambiguity between the techniGlI and ordinary senses of
21) leads to serious confusions Preterellees regarding others also posc f(x Plretian
welfllmiddotis111 Suppose Alf is a prude who ~1 sOllwwhat racy book such as Lady I LeweY It seems tlut
to Paretian wcltJris11I book cannot he approved of by the Pareto vorsc ofT whell she felds the book we might normally think she has right to
illditrerel1ce curve The way in which the Pareto principle call COI1shy
flict with all individuals rights to decide what she is to do has been analyzed All1arty~l Sen) Sen conceives of a person having 1 right as having lllthority to dtcicle the sociJi preference over at le~lst one pair of alterIlJtivts (xy) such that if~l person chooses x gt- l th1t is the social preference us cl11 this social prdlHllce xP)) and if the person chooses ygt- x then yPx (ie the social prellrence is y over x) Sen shows that attributing sllch rights to two persons and asslll11ing all possible of social states are permissible the s(leiJI olltcOl11e selected by the rights can conl1iet with a version of the Pareto
accordillg to which if fOf evcryone xgt- y then xfly That is if everyone prefers x to y then the social preferellce nHlst he x ()vtr y Sen nicely un1111arizes his lrgUll1ent
There is a book (eg Lilly Chatterleys L(1(I) which may be
read hy Mr A (the prude) or Mr B (the bscivious) or neither Given other things thest three alternatives define
social stHes ltI Ii and ) respectively Consider now the following possibility The A most (1 (no one
then l (Ill take the hurt on and lastly ) that lasciviolls lapping it up) The Iasciviol1s
prefers 1110St tl Cit will that lilywhite baby a lllce stwek) then b (it will be fun) and last () (whJt 1 waste of a book) 011 grounds of individual freedom si nee B wan ts to read the book rather than 110 one reading it
82
T
EFFICIENCY
sil1le A does not wallt to read it (l is soudly better than lt But t1 is Plreto-superior to
If)ltl
So we get hfl (by Mr Bs right) oPa (by Mr As md (f Ph Pareto since in both Mr As and Mr Bs lt1gt- b) so wt
gct lJoJgtiI))-m illtDllsitivl result Sell saw this not as a case rights but as showing the unalceptlbility of the 1lIITto universal ruk 11 Sometimes it seems that a cOJ11mitment [0 Pareto
ClIl ICHlllS astrIY lt- )I1C WIY to respolld to this problem is to
exclude sOl11e sorts of prcflrCllClS tjOIll cOllsiderltion thus we restrict Ollr weltlle Paretianislll to ellces over diftlrcllt Stltcs of ones own litc) and so ignore that other people do rather thm not do ccrtlill things not read Llther thlIl rcad ccruin hooks) But this solve all the
over lllany expellSlve OllCS Given thesc structures Pl1Tlian wclt~ms11l approves ofdistriblltiolls tint
r1l~e liS both to hiuhcr indifilrlnCl curves-- livilH llll lxplnih Illd 12 you
Fair and Unfair Starting Points Perhaps the 1llOSt seriolls probkll Pllltil11 wlIElI-isl1l is thlt it is instllsitive to the distributions ti-oll
which we Suppose thlt 111 of Alfs 111d
over quantities ofpiZlt 1l](1 chickcll wings hut and 111 the chickcli wings ami Bltty has nOllto
Pmto principle this is all dlicient distributioll Since Bctty hIS notil ing to t]J(Je thne is no way to nuke her bettll off without lllaklllg AII worse ()f1~ so wc have achieved Pareto optimality 13m this hardly setlllS a moral reason to e111hr1Cc the distribution Thc hl~lrt of the Paretian project is to make pcople hetter ofT and WhCIl no 011( call he made hettcr off without lowering S()llleOIH elses utility the Pareto criterion Ius llothing lllort to say---we hlv( achieved optil1lalitv_ But liol11 the perspective of advmcing 11l1111m Welf~l1T it is hard to
conceive of situ at lOllS where Betty has IlothiIlg lS optind Plausihle versiollS of Parltilll welfllism thus seelll COllllllitted to S0111( idca of1 flir starting point mel flim can hold that Plflto-lpproVld moves l111lk from the illitil t1ir startim poillt arc mOLll
83
(xlcrlulilic All
this impact 1S
bellefit
prodllcns or C(lIlUlIlcrs cost
11IlPOSlS extcrtlliities
I ratiollli ccollomic Igcnt Air
CHAPTER 3
32 EFFICIENCY EXTERNALITIES
AND PUBLIC GOODS
Externalities and Property Rights
to the cHIcielltour f(1ClIS tI0111 tile eltlcicllt
that you ideJ 1IS
our allalysls of all et1iciellt COllSlllllptioll decision you up to tbe point where your marginal bendits
your 111lrglllal costs lfyoll stop producing pizza wilile yuur
your Illanrinal l()sts it looks
pizza how l1lucb beln
benetlts are still greater thall
illsoClr as production of1I1 extr1 t~lCtion th1Il it costs (rlllItmber our concern is opportunity costs) To produce pizza above md the pOlIlt where your
bcnetlts equal yOUI lllarglllal costs 111lIllS thlt your LIst pin cost
you Illore (ill tLTlIlS of prdtTtIHT sltis6ction) than you received ill which again looks to be all irratiol11 decisioll So I ration11
lIllXilllizer will produce up to the point where her lllargilLIl
benetts equal her lIlargi 1111 costs
The nwbklll is that this lIeed not be the dticiellt level of
ClIglgC ill it up to the point were iis Illarginal bCl1dits ll]lIal iis costs
Alf willllot uke accollnt of the (mts to Betty But if AIr lip to tilt Jloillt wltere his IIIlrgilla] cmts lIld 11lnetits are there Irl additiollal cot to Betty it looks IS if the tot11 ()cial costs
(thl cost to All ami of Alls last unit of productioll lxceednl
tlte entire social bcndits This would violate thl Plreto cnterion AI
has Illoved them both to a 11l distributioll (with thl extrl
lInit of pizzl) which bendits Alf at I cost to Betty A sillli1r l11alysis applies to external bCllefits if Illy production 111 bClIdits to you 1S wcll as to Ille then if- I SlOp production whcn lily muginal bCl1dlts
Illy margiml costs fWIlI a socia] Doint of view (which includes
the bcnetits and costs to everyone) the social mamillal bcnefits still excecd socid 111argin11 osts sincl lily
not taken into account the bellefits you receive
84
EFFICIENCY
Extnmlities 1re a chlt-f source of market f~lilure-the ililurc of the market to produce eHicicllt results Oilly if Bltty)iilly illftTIIIlIics all
the costs alld belldts ofber lctiity will slie stop at just the poillt wlllrt
social lIluginai bendils clt]uII social lllnginal costs So too III a trade
IiAII1nd lkttv ftdlv mternalizt the costs lIld [wndts oCtheir trade
Clll Wl SIY lhe trade lllcesltlrilv moves lI) to l Parlto-sllplTior state If
then l1T tlllrdpartv costs extcl1ldiIlCS) AII llId Betty
Iluke trades where the soci1i marginal costs exceed the social
belldits because they do lint take ICCollnt of the costs to Chlrlic if
the
-----------~--~-~
[xlIeiits exist All llId Belly Illay Ilot tLltlC CVCll thollgh the
bendts lXCCld tlte sociallliarglllal costs
market would SCelll~()(IIICC ctticicllt outshy~- ~-s~~-~l~opert l~lgTt~-IllI~hv ~
--j--~- _--_ --------- - _shytCOllOIlIIC Igcllt illcllltliics ((11- dlld Jmcirs r IllS tlllilil) he
obtlillS the full bClldits Illd PIVS the fidl cost of his llllvlty
Consider thl lII kllO1I os ufthe trlgcdy olthe COIIIIIIOIIS such IS tisheris 1 MI1lY lisheries Irolllld till ~orid liT overtished result
illg ill ] deplctioll oftocks No it would IlroJlblv be to the belletit
of fishlr1l1llI Alf to rnlucl his each llext year it If( lIld h1 (IIilIIl lt lt)hlllillillI 111 lite liilre IIIs r(dll(1d rield Ihis ltlir But hl call1lot if lktty lIId CiJlrlic lish IIIYWI
the stocks will still 1)( dlpktn AII will hwc plid I cost but wlil llot
g1111 lhl full bllIdts orbis rcstLlillt COllvl1sciy Betty Illd Charlie do
lIot pay the full costs of their overllshlllg sillce the costs of Ire trallsi(rnd to other tlshermcll slich ]S Alf Thlls the fisherics 11(
lIld the IIl1rgill1I socid costs lxcecd till lI]1rgill11 bell efi tgt
A schellll tklt illllrnliI7ld III costs lIld bendit -~-u-fJ~~-T the probklli Cltllme we hIVl this
IWClllSl p1llperty rights OHT iish in the onI11 Ire (lItticult to
probll1I1
tiollllizl (tlsh tllId to swilll IWlllld I
I-OVlVer thl ide11 of] SystlllI or property rights th]t illtlr1]lhzcs
benciit Ind cols is lIllre1Iizlblc II II less we restnct vhat Ullints IS 11
l~tlrtli1ity Think abollt SUIs case ofMr Prlldes alld Mr laclviouss
abollt rladillg Lad) L11lIIcrlC(S LtlllT If Mr LISliviom extrLilS 1m ngln l1ld rC1ds till hook thnl is all Mr Prude IS 11ll(k or on~ SIIKl Mr Prude prlill tllal 110 olle
rcads it to Mr Lasclviolls rcldillg it Mr LlscivlOliS It] lJlgltivdy
impactcd the utility fUllctiol1 of Mr Prude If people havc prCflrllHes over thell extlrI1alillcs will hl tVtlYhl~
-- - AlfprdlTs tlw people shop at farget tT WI-Mlrt if
so every tLlIlSlctlOI1 at Wal-Mart involves a Ilegtivl
85
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
CHAPTER 3
the Pareto critenol must he violated wclbre economist llld Parctiall adopttd what is known t the
llllit(JrllL sOllle
han
dislrilJIIlilll J) 110 OJ is (1ell 111111 SOIlC lose U) IIIOIllIgIOIiI lJ I 10
(IS IllllSC 11110 do lite IlIllle could laquo1111pCIISIle IiiI loSls - To grasp what it l1IellllS to say that a persoll wilid be
t()r a cOllsider AIf~ who wc m is the
sole persoll who has hetLL 11Lilde worse tht 11I0ve tlOI1l Dl to 1)2
make the casc SlllLp1lt asUlI]( that lverYOl1C else is hctter otr ill D21 To say that All ha bccll madc worse 011 llleIIlS that he is Oil a lowcr iLlditllTl1ce curve ill I) thaLl hl was ill I) I Nox iLlLagilll
after the move to I) the trallSterred ellough of their to Alf [() raise hill hlck to thl iLlditl(rcllce curve tint he
this would brillg Ilbout a Ilew distrihutioll 1 ) which is iLldced
to I) I because everyolle etelt All is It II higher indifflTlLlcl curve ill I) thl1l they were ill ))1 Illld Al(i LlOW back
OJl the lIlle inditllilLlCl cUne (as he vIlS ill l) 1 W l CllIl say
thlt 1)2 i Kaldor-Hicks Paretosllperior to 1)1 iftlllrc is a distribution I) that (I) could be L1roduced bv rldistribulilll the 1110Vlllg Iiom I) I to I) alld I) is the llorJlul larlloshy
) and (2) 1lS hcCII
has bl~n
to I) I Note the Kaldor-llicks test SllyS that to I) I (1(1
I )jstrihutioll I) is that ill which
lllade bllt Kaldor-Ilicks docs lIot say silllpl) thlt I) is Plrctoshy
to (more dllcicLltto 1)1 it says thlt I) is
I) 1 evell thollgh SOIllC pcopk the 1110VC llOlll 1)1 to 1)2 Belallsl Iraquo (ltlIld becausc I) 1I(1111d be Pareto -sllperior to I) I
Paleto-sllplTior to I) 1
To lIUllY tIllS S(lIllS
blSCd Oil the dClllld tht vcry odd
fill SOllle ClIIl
illcurrld losses give rise to I) alld I) is Kaldor-I-Jeks
which WlS
IS lOW elllployell to
DtlLers The lllove iolll I) that hellLtit SOllll at the expCIlSl of
to 1)1 lIukes Stlllll peop1lt worse ofl~ yet it IS Iusttlell as a
backdoor way of
alld gil ins within II Paretillll tiullcwork
Kaldor-Hicks looks like a
U)lllplmSlJllS of utilit loss
Even if we put aside the controvlTsilll Iltaldor-Ilicks interpnlltioll
or the Plrlto crittrioll llJOll rdlectioll thl Panto test is l10t as U11COI1middot
troversid as is ofkll thought Much othl lppllll of the Parltu criterion
lies ill the question Who could posltibly object to all improvell1ent that lllakes everYOlll better olP Figure ~f suggests IIll answer
80
r EFFICIENCY
--_93 Bettys
Dgt
o utility
FIG U R E 3-4 A Series of Paretian Moves
wc start at point O and lliake the Plnto-superlOr l1l0Ve to
A which is OIlL possible distributioll alollg l) I the Plrlto
Frolltier the set of possibk Plllto improvemLllts frolll O Ollct WL
are It A tht Pareto impwvcllltllts to I)gt Ilrl liLllitld to thosl lwtwttll
poillts W llld X other thllli ill l) I so are llot Pareto illlproVllllCllts Assume thcll tInt at soml
distributioll 1)2 becolllcs 1 poisibllity Alf llld Bctty makc the
Pareto move to poillt B 011 1)2 Suppose now that ill the ttlture 1)1
becolllcs possibk llO the possible PIlrLto improveLlllms are limited to
thOSl bllillg bctelll Y and Z We em sce that successive applicatiollS
of the Parcto critcrloll Illove distrihwiollS alollg a plth that is incHs
illglv [wlldieill to AlfaLld urless bCllefit to Bctty Ifwc Iud bcell abk to
JUIllP to I) all at Ollce cvcrythillgoll it would be1 Pareto over 0 hut ollce we have llladc the interlllediatc lllOVeS to A IlIld B
lllOSt of 1) is cduded by the Plfeto crlterio]l Perhaps
would havc good rcaSOll to objcct to the illitial Pareto LllOVC to The Pareto prillciple allows a wide rJllgc of movcs llld it Illay matter a
lot which of those is 1Cltllllly made alld ill whlt ordeL
Welfare and Preferences aside thest problems with the
Plrcto criterioll it also SlelllS doubttttl that we should accept the
idciltiticatiuLl of prelerlIlCe SJtlsLlctioll with welflre We llve
cell that prekrlllcls Illld lot be Jbnut olles own good or self
interest anytilllc OllC rallks all outcome above another Olle hilS 1
21) llClll our last-Llllmgo rdtslr frolll Sectioll
is llot to take the List LlllllgO though as Slll llotlS
she would like thJt lllJllgO and would WdCOlllC SOllleOlle thrustillg
81
CHAPTER 3
the mango on her III that case it seel11S doubtful that we should say that her welfare is enhanced by satistying her pnferellce not to take the last mango since her civility preference instructs her not to do what would be good filr her Those who identity wef1re with preference satisfaction often simply seem driven to stipulating that in this case ones wel6re IIIl1sf be advanced because one is what one prefers Here I think is a perfect example of the way that the ambiguity between the techniGlI and ordinary senses of
21) leads to serious confusions Preterellees regarding others also posc f(x Plretian
welfllmiddotis111 Suppose Alf is a prude who ~1 sOllwwhat racy book such as Lady I LeweY It seems tlut
to Paretian wcltJris11I book cannot he approved of by the Pareto vorsc ofT whell she felds the book we might normally think she has right to
illditrerel1ce curve The way in which the Pareto principle call COI1shy
flict with all individuals rights to decide what she is to do has been analyzed All1arty~l Sen) Sen conceives of a person having 1 right as having lllthority to dtcicle the sociJi preference over at le~lst one pair of alterIlJtivts (xy) such that if~l person chooses x gt- l th1t is the social preference us cl11 this social prdlHllce xP)) and if the person chooses ygt- x then yPx (ie the social prellrence is y over x) Sen shows that attributing sllch rights to two persons and asslll11ing all possible of social states are permissible the s(leiJI olltcOl11e selected by the rights can conl1iet with a version of the Pareto
accordillg to which if fOf evcryone xgt- y then xfly That is if everyone prefers x to y then the social preferellce nHlst he x ()vtr y Sen nicely un1111arizes his lrgUll1ent
There is a book (eg Lilly Chatterleys L(1(I) which may be
read hy Mr A (the prude) or Mr B (the bscivious) or neither Given other things thest three alternatives define
social stHes ltI Ii and ) respectively Consider now the following possibility The A most (1 (no one
then l (Ill take the hurt on and lastly ) that lasciviolls lapping it up) The Iasciviol1s
prefers 1110St tl Cit will that lilywhite baby a lllce stwek) then b (it will be fun) and last () (whJt 1 waste of a book) 011 grounds of individual freedom si nee B wan ts to read the book rather than 110 one reading it
82
T
EFFICIENCY
sil1le A does not wallt to read it (l is soudly better than lt But t1 is Plreto-superior to
If)ltl
So we get hfl (by Mr Bs right) oPa (by Mr As md (f Ph Pareto since in both Mr As and Mr Bs lt1gt- b) so wt
gct lJoJgtiI))-m illtDllsitivl result Sell saw this not as a case rights but as showing the unalceptlbility of the 1lIITto universal ruk 11 Sometimes it seems that a cOJ11mitment [0 Pareto
ClIl ICHlllS astrIY lt- )I1C WIY to respolld to this problem is to
exclude sOl11e sorts of prcflrCllClS tjOIll cOllsiderltion thus we restrict Ollr weltlle Paretianislll to ellces over diftlrcllt Stltcs of ones own litc) and so ignore that other people do rather thm not do ccrtlill things not read Llther thlIl rcad ccruin hooks) But this solve all the
over lllany expellSlve OllCS Given thesc structures Pl1Tlian wclt~ms11l approves ofdistriblltiolls tint
r1l~e liS both to hiuhcr indifilrlnCl curves-- livilH llll lxplnih Illd 12 you
Fair and Unfair Starting Points Perhaps the 1llOSt seriolls probkll Pllltil11 wlIElI-isl1l is thlt it is instllsitive to the distributions ti-oll
which we Suppose thlt 111 of Alfs 111d
over quantities ofpiZlt 1l](1 chickcll wings hut and 111 the chickcli wings ami Bltty has nOllto
Pmto principle this is all dlicient distributioll Since Bctty hIS notil ing to t]J(Je thne is no way to nuke her bettll off without lllaklllg AII worse ()f1~ so wc have achieved Pareto optimality 13m this hardly setlllS a moral reason to e111hr1Cc the distribution Thc hl~lrt of the Paretian project is to make pcople hetter ofT and WhCIl no 011( call he made hettcr off without lowering S()llleOIH elses utility the Pareto criterion Ius llothing lllort to say---we hlv( achieved optil1lalitv_ But liol11 the perspective of advmcing 11l1111m Welf~l1T it is hard to
conceive of situ at lOllS where Betty has IlothiIlg lS optind Plausihle versiollS of Parltilll welfllism thus seelll COllllllitted to S0111( idca of1 flir starting point mel flim can hold that Plflto-lpproVld moves l111lk from the illitil t1ir startim poillt arc mOLll
83
(xlcrlulilic All
this impact 1S
bellefit
prodllcns or C(lIlUlIlcrs cost
11IlPOSlS extcrtlliities
I ratiollli ccollomic Igcnt Air
CHAPTER 3
32 EFFICIENCY EXTERNALITIES
AND PUBLIC GOODS
Externalities and Property Rights
to the cHIcielltour f(1ClIS tI0111 tile eltlcicllt
that you ideJ 1IS
our allalysls of all et1iciellt COllSlllllptioll decision you up to tbe point where your marginal bendits
your 111lrglllal costs lfyoll stop producing pizza wilile yuur
your Illanrinal l()sts it looks
pizza how l1lucb beln
benetlts are still greater thall
illsoClr as production of1I1 extr1 t~lCtion th1Il it costs (rlllItmber our concern is opportunity costs) To produce pizza above md the pOlIlt where your
bcnetlts equal yOUI lllarglllal costs 111lIllS thlt your LIst pin cost
you Illore (ill tLTlIlS of prdtTtIHT sltis6ction) than you received ill which again looks to be all irratiol11 decisioll So I ration11
lIllXilllizer will produce up to the point where her lllargilLIl
benetts equal her lIlargi 1111 costs
The nwbklll is that this lIeed not be the dticiellt level of
ClIglgC ill it up to the point were iis Illarginal bCl1dits ll]lIal iis costs
Alf willllot uke accollnt of the (mts to Betty But if AIr lip to tilt Jloillt wltere his IIIlrgilla] cmts lIld 11lnetits are there Irl additiollal cot to Betty it looks IS if the tot11 ()cial costs
(thl cost to All ami of Alls last unit of productioll lxceednl
tlte entire social bcndits This would violate thl Plreto cnterion AI
has Illoved them both to a 11l distributioll (with thl extrl
lInit of pizzl) which bendits Alf at I cost to Betty A sillli1r l11alysis applies to external bCllefits if Illy production 111 bClIdits to you 1S wcll as to Ille then if- I SlOp production whcn lily muginal bCl1dlts
Illy margiml costs fWIlI a socia] Doint of view (which includes
the bcnetits and costs to everyone) the social mamillal bcnefits still excecd socid 111argin11 osts sincl lily
not taken into account the bellefits you receive
84
EFFICIENCY
Extnmlities 1re a chlt-f source of market f~lilure-the ililurc of the market to produce eHicicllt results Oilly if Bltty)iilly illftTIIIlIics all
the costs alld belldts ofber lctiity will slie stop at just the poillt wlllrt
social lIluginai bendils clt]uII social lllnginal costs So too III a trade
IiAII1nd lkttv ftdlv mternalizt the costs lIld [wndts oCtheir trade
Clll Wl SIY lhe trade lllcesltlrilv moves lI) to l Parlto-sllplTior state If
then l1T tlllrdpartv costs extcl1ldiIlCS) AII llId Betty
Iluke trades where the soci1i marginal costs exceed the social
belldits because they do lint take ICCollnt of the costs to Chlrlic if
the
-----------~--~-~
[xlIeiits exist All llId Belly Illay Ilot tLltlC CVCll thollgh the
bendts lXCCld tlte sociallliarglllal costs
market would SCelll~()(IIICC ctticicllt outshy~- ~-s~~-~l~opert l~lgTt~-IllI~hv ~
--j--~- _--_ --------- - _shytCOllOIlIIC Igcllt illcllltliics ((11- dlld Jmcirs r IllS tlllilil) he
obtlillS the full bClldits Illd PIVS the fidl cost of his llllvlty
Consider thl lII kllO1I os ufthe trlgcdy olthe COIIIIIIOIIS such IS tisheris 1 MI1lY lisheries Irolllld till ~orid liT overtished result
illg ill ] deplctioll oftocks No it would IlroJlblv be to the belletit
of fishlr1l1llI Alf to rnlucl his each llext year it If( lIld h1 (IIilIIl lt lt)hlllillillI 111 lite liilre IIIs r(dll(1d rield Ihis ltlir But hl call1lot if lktty lIId CiJlrlic lish IIIYWI
the stocks will still 1)( dlpktn AII will hwc plid I cost but wlil llot
g1111 lhl full bllIdts orbis rcstLlillt COllvl1sciy Betty Illd Charlie do
lIot pay the full costs of their overllshlllg sillce the costs of Ire trallsi(rnd to other tlshermcll slich ]S Alf Thlls the fisherics 11(
lIld the IIl1rgill1I socid costs lxcecd till lI]1rgill11 bell efi tgt
A schellll tklt illllrnliI7ld III costs lIld bendit -~-u-fJ~~-T the probklli Cltllme we hIVl this
IWClllSl p1llperty rights OHT iish in the onI11 Ire (lItticult to
probll1I1
tiollllizl (tlsh tllId to swilll IWlllld I
I-OVlVer thl ide11 of] SystlllI or property rights th]t illtlr1]lhzcs
benciit Ind cols is lIllre1Iizlblc II II less we restnct vhat Ullints IS 11
l~tlrtli1ity Think abollt SUIs case ofMr Prlldes alld Mr laclviouss
abollt rladillg Lad) L11lIIcrlC(S LtlllT If Mr LISliviom extrLilS 1m ngln l1ld rC1ds till hook thnl is all Mr Prude IS 11ll(k or on~ SIIKl Mr Prude prlill tllal 110 olle
rcads it to Mr Lasclviolls rcldillg it Mr LlscivlOliS It] lJlgltivdy
impactcd the utility fUllctiol1 of Mr Prude If people havc prCflrllHes over thell extlrI1alillcs will hl tVtlYhl~
-- - AlfprdlTs tlw people shop at farget tT WI-Mlrt if
so every tLlIlSlctlOI1 at Wal-Mart involves a Ilegtivl
85
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
CHAPTER 3
the mango on her III that case it seel11S doubtful that we should say that her welfare is enhanced by satistying her pnferellce not to take the last mango since her civility preference instructs her not to do what would be good filr her Those who identity wef1re with preference satisfaction often simply seem driven to stipulating that in this case ones wel6re IIIl1sf be advanced because one is what one prefers Here I think is a perfect example of the way that the ambiguity between the techniGlI and ordinary senses of
21) leads to serious confusions Preterellees regarding others also posc f(x Plretian
welfllmiddotis111 Suppose Alf is a prude who ~1 sOllwwhat racy book such as Lady I LeweY It seems tlut
to Paretian wcltJris11I book cannot he approved of by the Pareto vorsc ofT whell she felds the book we might normally think she has right to
illditrerel1ce curve The way in which the Pareto principle call COI1shy
flict with all individuals rights to decide what she is to do has been analyzed All1arty~l Sen) Sen conceives of a person having 1 right as having lllthority to dtcicle the sociJi preference over at le~lst one pair of alterIlJtivts (xy) such that if~l person chooses x gt- l th1t is the social preference us cl11 this social prdlHllce xP)) and if the person chooses ygt- x then yPx (ie the social prellrence is y over x) Sen shows that attributing sllch rights to two persons and asslll11ing all possible of social states are permissible the s(leiJI olltcOl11e selected by the rights can conl1iet with a version of the Pareto
accordillg to which if fOf evcryone xgt- y then xfly That is if everyone prefers x to y then the social preferellce nHlst he x ()vtr y Sen nicely un1111arizes his lrgUll1ent
There is a book (eg Lilly Chatterleys L(1(I) which may be
read hy Mr A (the prude) or Mr B (the bscivious) or neither Given other things thest three alternatives define
social stHes ltI Ii and ) respectively Consider now the following possibility The A most (1 (no one
then l (Ill take the hurt on and lastly ) that lasciviolls lapping it up) The Iasciviol1s
prefers 1110St tl Cit will that lilywhite baby a lllce stwek) then b (it will be fun) and last () (whJt 1 waste of a book) 011 grounds of individual freedom si nee B wan ts to read the book rather than 110 one reading it
82
T
EFFICIENCY
sil1le A does not wallt to read it (l is soudly better than lt But t1 is Plreto-superior to
If)ltl
So we get hfl (by Mr Bs right) oPa (by Mr As md (f Ph Pareto since in both Mr As and Mr Bs lt1gt- b) so wt
gct lJoJgtiI))-m illtDllsitivl result Sell saw this not as a case rights but as showing the unalceptlbility of the 1lIITto universal ruk 11 Sometimes it seems that a cOJ11mitment [0 Pareto
ClIl ICHlllS astrIY lt- )I1C WIY to respolld to this problem is to
exclude sOl11e sorts of prcflrCllClS tjOIll cOllsiderltion thus we restrict Ollr weltlle Paretianislll to ellces over diftlrcllt Stltcs of ones own litc) and so ignore that other people do rather thm not do ccrtlill things not read Llther thlIl rcad ccruin hooks) But this solve all the
over lllany expellSlve OllCS Given thesc structures Pl1Tlian wclt~ms11l approves ofdistriblltiolls tint
r1l~e liS both to hiuhcr indifilrlnCl curves-- livilH llll lxplnih Illd 12 you
Fair and Unfair Starting Points Perhaps the 1llOSt seriolls probkll Pllltil11 wlIElI-isl1l is thlt it is instllsitive to the distributions ti-oll
which we Suppose thlt 111 of Alfs 111d
over quantities ofpiZlt 1l](1 chickcll wings hut and 111 the chickcli wings ami Bltty has nOllto
Pmto principle this is all dlicient distributioll Since Bctty hIS notil ing to t]J(Je thne is no way to nuke her bettll off without lllaklllg AII worse ()f1~ so wc have achieved Pareto optimality 13m this hardly setlllS a moral reason to e111hr1Cc the distribution Thc hl~lrt of the Paretian project is to make pcople hetter ofT and WhCIl no 011( call he made hettcr off without lowering S()llleOIH elses utility the Pareto criterion Ius llothing lllort to say---we hlv( achieved optil1lalitv_ But liol11 the perspective of advmcing 11l1111m Welf~l1T it is hard to
conceive of situ at lOllS where Betty has IlothiIlg lS optind Plausihle versiollS of Parltilll welfllism thus seelll COllllllitted to S0111( idca of1 flir starting point mel flim can hold that Plflto-lpproVld moves l111lk from the illitil t1ir startim poillt arc mOLll
83
(xlcrlulilic All
this impact 1S
bellefit
prodllcns or C(lIlUlIlcrs cost
11IlPOSlS extcrtlliities
I ratiollli ccollomic Igcnt Air
CHAPTER 3
32 EFFICIENCY EXTERNALITIES
AND PUBLIC GOODS
Externalities and Property Rights
to the cHIcielltour f(1ClIS tI0111 tile eltlcicllt
that you ideJ 1IS
our allalysls of all et1iciellt COllSlllllptioll decision you up to tbe point where your marginal bendits
your 111lrglllal costs lfyoll stop producing pizza wilile yuur
your Illanrinal l()sts it looks
pizza how l1lucb beln
benetlts are still greater thall
illsoClr as production of1I1 extr1 t~lCtion th1Il it costs (rlllItmber our concern is opportunity costs) To produce pizza above md the pOlIlt where your
bcnetlts equal yOUI lllarglllal costs 111lIllS thlt your LIst pin cost
you Illore (ill tLTlIlS of prdtTtIHT sltis6ction) than you received ill which again looks to be all irratiol11 decisioll So I ration11
lIllXilllizer will produce up to the point where her lllargilLIl
benetts equal her lIlargi 1111 costs
The nwbklll is that this lIeed not be the dticiellt level of
ClIglgC ill it up to the point were iis Illarginal bCl1dits ll]lIal iis costs
Alf willllot uke accollnt of the (mts to Betty But if AIr lip to tilt Jloillt wltere his IIIlrgilla] cmts lIld 11lnetits are there Irl additiollal cot to Betty it looks IS if the tot11 ()cial costs
(thl cost to All ami of Alls last unit of productioll lxceednl
tlte entire social bcndits This would violate thl Plreto cnterion AI
has Illoved them both to a 11l distributioll (with thl extrl
lInit of pizzl) which bendits Alf at I cost to Betty A sillli1r l11alysis applies to external bCllefits if Illy production 111 bClIdits to you 1S wcll as to Ille then if- I SlOp production whcn lily muginal bCl1dlts
Illy margiml costs fWIlI a socia] Doint of view (which includes
the bcnetits and costs to everyone) the social mamillal bcnefits still excecd socid 111argin11 osts sincl lily
not taken into account the bellefits you receive
84
EFFICIENCY
Extnmlities 1re a chlt-f source of market f~lilure-the ililurc of the market to produce eHicicllt results Oilly if Bltty)iilly illftTIIIlIics all
the costs alld belldts ofber lctiity will slie stop at just the poillt wlllrt
social lIluginai bendils clt]uII social lllnginal costs So too III a trade
IiAII1nd lkttv ftdlv mternalizt the costs lIld [wndts oCtheir trade
Clll Wl SIY lhe trade lllcesltlrilv moves lI) to l Parlto-sllplTior state If
then l1T tlllrdpartv costs extcl1ldiIlCS) AII llId Betty
Iluke trades where the soci1i marginal costs exceed the social
belldits because they do lint take ICCollnt of the costs to Chlrlic if
the
-----------~--~-~
[xlIeiits exist All llId Belly Illay Ilot tLltlC CVCll thollgh the
bendts lXCCld tlte sociallliarglllal costs
market would SCelll~()(IIICC ctticicllt outshy~- ~-s~~-~l~opert l~lgTt~-IllI~hv ~
--j--~- _--_ --------- - _shytCOllOIlIIC Igcllt illcllltliics ((11- dlld Jmcirs r IllS tlllilil) he
obtlillS the full bClldits Illd PIVS the fidl cost of his llllvlty
Consider thl lII kllO1I os ufthe trlgcdy olthe COIIIIIIOIIS such IS tisheris 1 MI1lY lisheries Irolllld till ~orid liT overtished result
illg ill ] deplctioll oftocks No it would IlroJlblv be to the belletit
of fishlr1l1llI Alf to rnlucl his each llext year it If( lIld h1 (IIilIIl lt lt)hlllillillI 111 lite liilre IIIs r(dll(1d rield Ihis ltlir But hl call1lot if lktty lIId CiJlrlic lish IIIYWI
the stocks will still 1)( dlpktn AII will hwc plid I cost but wlil llot
g1111 lhl full bllIdts orbis rcstLlillt COllvl1sciy Betty Illd Charlie do
lIot pay the full costs of their overllshlllg sillce the costs of Ire trallsi(rnd to other tlshermcll slich ]S Alf Thlls the fisherics 11(
lIld the IIl1rgill1I socid costs lxcecd till lI]1rgill11 bell efi tgt
A schellll tklt illllrnliI7ld III costs lIld bendit -~-u-fJ~~-T the probklli Cltllme we hIVl this
IWClllSl p1llperty rights OHT iish in the onI11 Ire (lItticult to
probll1I1
tiollllizl (tlsh tllId to swilll IWlllld I
I-OVlVer thl ide11 of] SystlllI or property rights th]t illtlr1]lhzcs
benciit Ind cols is lIllre1Iizlblc II II less we restnct vhat Ullints IS 11
l~tlrtli1ity Think abollt SUIs case ofMr Prlldes alld Mr laclviouss
abollt rladillg Lad) L11lIIcrlC(S LtlllT If Mr LISliviom extrLilS 1m ngln l1ld rC1ds till hook thnl is all Mr Prude IS 11ll(k or on~ SIIKl Mr Prude prlill tllal 110 olle
rcads it to Mr Lasclviolls rcldillg it Mr LlscivlOliS It] lJlgltivdy
impactcd the utility fUllctiol1 of Mr Prude If people havc prCflrllHes over thell extlrI1alillcs will hl tVtlYhl~
-- - AlfprdlTs tlw people shop at farget tT WI-Mlrt if
so every tLlIlSlctlOI1 at Wal-Mart involves a Ilegtivl
85
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
(xlcrlulilic All
this impact 1S
bellefit
prodllcns or C(lIlUlIlcrs cost
11IlPOSlS extcrtlliities
I ratiollli ccollomic Igcnt Air
CHAPTER 3
32 EFFICIENCY EXTERNALITIES
AND PUBLIC GOODS
Externalities and Property Rights
to the cHIcielltour f(1ClIS tI0111 tile eltlcicllt
that you ideJ 1IS
our allalysls of all et1iciellt COllSlllllptioll decision you up to tbe point where your marginal bendits
your 111lrglllal costs lfyoll stop producing pizza wilile yuur
your Illanrinal l()sts it looks
pizza how l1lucb beln
benetlts are still greater thall
illsoClr as production of1I1 extr1 t~lCtion th1Il it costs (rlllItmber our concern is opportunity costs) To produce pizza above md the pOlIlt where your
bcnetlts equal yOUI lllarglllal costs 111lIllS thlt your LIst pin cost
you Illore (ill tLTlIlS of prdtTtIHT sltis6ction) than you received ill which again looks to be all irratiol11 decisioll So I ration11
lIllXilllizer will produce up to the point where her lllargilLIl
benetts equal her lIlargi 1111 costs
The nwbklll is that this lIeed not be the dticiellt level of
ClIglgC ill it up to the point were iis Illarginal bCl1dits ll]lIal iis costs
Alf willllot uke accollnt of the (mts to Betty But if AIr lip to tilt Jloillt wltere his IIIlrgilla] cmts lIld 11lnetits are there Irl additiollal cot to Betty it looks IS if the tot11 ()cial costs
(thl cost to All ami of Alls last unit of productioll lxceednl
tlte entire social bcndits This would violate thl Plreto cnterion AI
has Illoved them both to a 11l distributioll (with thl extrl
lInit of pizzl) which bendits Alf at I cost to Betty A sillli1r l11alysis applies to external bCllefits if Illy production 111 bClIdits to you 1S wcll as to Ille then if- I SlOp production whcn lily muginal bCl1dlts
Illy margiml costs fWIlI a socia] Doint of view (which includes
the bcnetits and costs to everyone) the social mamillal bcnefits still excecd socid 111argin11 osts sincl lily
not taken into account the bellefits you receive
84
EFFICIENCY
Extnmlities 1re a chlt-f source of market f~lilure-the ililurc of the market to produce eHicicllt results Oilly if Bltty)iilly illftTIIIlIics all
the costs alld belldts ofber lctiity will slie stop at just the poillt wlllrt
social lIluginai bendils clt]uII social lllnginal costs So too III a trade
IiAII1nd lkttv ftdlv mternalizt the costs lIld [wndts oCtheir trade
Clll Wl SIY lhe trade lllcesltlrilv moves lI) to l Parlto-sllplTior state If
then l1T tlllrdpartv costs extcl1ldiIlCS) AII llId Betty
Iluke trades where the soci1i marginal costs exceed the social
belldits because they do lint take ICCollnt of the costs to Chlrlic if
the
-----------~--~-~
[xlIeiits exist All llId Belly Illay Ilot tLltlC CVCll thollgh the
bendts lXCCld tlte sociallliarglllal costs
market would SCelll~()(IIICC ctticicllt outshy~- ~-s~~-~l~opert l~lgTt~-IllI~hv ~
--j--~- _--_ --------- - _shytCOllOIlIIC Igcllt illcllltliics ((11- dlld Jmcirs r IllS tlllilil) he
obtlillS the full bClldits Illd PIVS the fidl cost of his llllvlty
Consider thl lII kllO1I os ufthe trlgcdy olthe COIIIIIIOIIS such IS tisheris 1 MI1lY lisheries Irolllld till ~orid liT overtished result
illg ill ] deplctioll oftocks No it would IlroJlblv be to the belletit
of fishlr1l1llI Alf to rnlucl his each llext year it If( lIld h1 (IIilIIl lt lt)hlllillillI 111 lite liilre IIIs r(dll(1d rield Ihis ltlir But hl call1lot if lktty lIId CiJlrlic lish IIIYWI
the stocks will still 1)( dlpktn AII will hwc plid I cost but wlil llot
g1111 lhl full bllIdts orbis rcstLlillt COllvl1sciy Betty Illd Charlie do
lIot pay the full costs of their overllshlllg sillce the costs of Ire trallsi(rnd to other tlshermcll slich ]S Alf Thlls the fisherics 11(
lIld the IIl1rgill1I socid costs lxcecd till lI]1rgill11 bell efi tgt
A schellll tklt illllrnliI7ld III costs lIld bendit -~-u-fJ~~-T the probklli Cltllme we hIVl this
IWClllSl p1llperty rights OHT iish in the onI11 Ire (lItticult to
probll1I1
tiollllizl (tlsh tllId to swilll IWlllld I
I-OVlVer thl ide11 of] SystlllI or property rights th]t illtlr1]lhzcs
benciit Ind cols is lIllre1Iizlblc II II less we restnct vhat Ullints IS 11
l~tlrtli1ity Think abollt SUIs case ofMr Prlldes alld Mr laclviouss
abollt rladillg Lad) L11lIIcrlC(S LtlllT If Mr LISliviom extrLilS 1m ngln l1ld rC1ds till hook thnl is all Mr Prude IS 11ll(k or on~ SIIKl Mr Prude prlill tllal 110 olle
rcads it to Mr Lasclviolls rcldillg it Mr LlscivlOliS It] lJlgltivdy
impactcd the utility fUllctiol1 of Mr Prude If people havc prCflrllHes over thell extlrI1alillcs will hl tVtlYhl~
-- - AlfprdlTs tlw people shop at farget tT WI-Mlrt if
so every tLlIlSlctlOI1 at Wal-Mart involves a Ilegtivl
85
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
EFFICIENCYCHAPTER 3
be said to illlpose recogniznl social costs 011 OtlHTS whcn certain interests which ought to be considered
One possible solution to this difficulty might be called the r(lllsshy
liascd 1011111011 to which Alfs actioll h~ls a negative external-Betty if and only if it violates a right of lkttys Rights we
i1llpinging Oil Ihose
individual The rightsshyconstitutes cost who was especially based solution to other ttlr every
to otherscost they Impose upon dont like Mill fiOI11 performing lctions that their
should~lrgued that slich costs should be ignored md set back
as rights 1(
Thus says
lIltliction OIl thC1ll or lilY loss tllsdlOOd or
unfJir or ungencrous usc of
over them even eHish abstincncc frolll dd(lldshy
injury---these arc lit of morallIlg them ill grave cases of ll10ral retribution andreprobatioll
1 17PUIlIS 1ll1ellt
The idea then is that we identity a crucial set of intellt~ (or sets of prefercnces over certain aspccts of ollr lite) and hold that if an action or transaction imposes costs 011 other parties ill tenm of tliese I)cirshyCII(CS the action or transaction has a sorill cost rights h]ve heel]
That the lCtiOl1 involves a s(lei11 cost doe not show that it
should be [)fohibited since the social bcnefits Illay still OlltWllgh tht
costs I K
This results in I 1l1Oralistic knuw which subscts of a persons prdcrcJlces are rights bd(lrc we elll know what constitutes all eHlUlnt level of lCtivity It IS Mill el1lphltiCllly lrgucd 110 one has l right that others dont read (rather thaIl reael) books onc tlnds offensive Mr Prude incur 110 cost when Mr Lasciviolls reads Lady CIIil I IcrC) s LOFershythere is no externality became IlO right was viobted There arc
real worries about this moralistic view For Olle it dots not make sense of a core argument of most liberal political econol1lists
viz that we should evaluate systellls of ri~hts ill terllls of their efficiency-promoting characteristics If we are to say that property rights promote eftlciellcy we must be able to first what an efficiellt level of production would be ami then show that
Jre apt to result ill this level But to solution we must know what our property and other we call identify externalities and so etTiciellt outshy
cOllles Say that Alf vallts to build a LlvenJ on his land and objects What is the eHlcient outcollle If Alf has the 011 his side thell the efficiellt outcome is that he builds it if Betty Ius the rights Oil her side she h1s J right not to have her property v~lllles
lowered by living Ilext to a tavern-then the et11cicllt outcome is that the tavern is Ilot built Ifboth have rihts then we must still sOInellOw
up the costs and benefits Ronald Coase proposes
view on Coases view lChievillg all etlitient outcome does not depend Oil thl way that the illiti~]l
Suppose that we live in a world flTe of trmsactioll and l)~lrgallllllg costs and in this world Alf has a flCtory that produces vhatchacallits tint generates smoke as a by-produlmiddott suppose that Betty has a lll1ndry llId
her costs Ire increased because of the Slllokl frolll Alfs tactory Alls products a ncg]tiw externality So if Alf produccs
whatchlcl11its up to the point whlTl hi lllarginal costs equal his nLlrshytoo many whatchacallit~ will bc produced Suppose that
per year Betty presently earns $24000 fIolH her but she would make $3 L()O() if Alfs sllloke didllt illne~N
her costs AlL theil Ill
against pollutioll we call still achieve Pareto ctllClcncy Iktty em pay Alf$()(JJ to stop producing whatchlcIllits he will be hetter otralld so will she so thc 11IOC is Pareto-superior
It is importallt that Coascs theorelll applies rlglrd1ess of how the property rights arc divided betwelll Alf and Betty 1 Pareto outCOllll Gill be reached whether All Ius a right to pollutl or Betty has 1 right that he llot pollute SUPPOSl that Alf is now lllaking $ ](IO()() proshy
whatchacallits while Bettvs llrotlts rCl1)l1l the SlIl1e f2t()()()
has
her $7( J() 1 to rdi-ain from According to theu ill tile IlhsCII(C cr trIISII(filll Inri
costs parlies to 1m WliFit) IPitil exmltllities 11111 (~lln 10 Sllll
alNdtloll lr resollrces I(I(JI(Icss of til( illilitll dislriiJlfliOIl or ropcrl) rllhs
Coases theorem calls into qUlstion olle of the traditional jllstificJtiolls for government regu1JtiolJ In the abselKe of a peJillt schellll of propshyerty rirrhts that internalizes both costs Illd 1)llletiti it has beell widely
8786
~
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
CHAPTER 3 EFFICIENCY
government is necessJry to re6rulate the l1larket fililure that
nsults from externalities l3ut Coase shows that Illarket trallSlctiollS
em solve the problel1l of externalities and get us outcome (thOtllh the actual costs involved in
precludc
Public Goods
Rebted to the question of extcrnalitie is the special ClC of Public Loods Jr( defllled in tenllS of two charlctnistilmiddots [)irs
Consider clem air I f it
lway tiOIl1 Betty Once tht good is then consulllcrs do not compete fx it everyolle can fi-ccly lise II withollt diminishing the amollllt left ft)r others Suolld we Cl1lllot control the flogt ofbcnditi tiolll plIhhc
lre IollcwlldiJc If a public goud is provided it is
provided f()r all to use If we clean the air cveryolle 1lIS c1cm lir
We canllot exclude those who hlvc llot 11lid their share A pure is one that meets these two conditiolls In most
lIe thus
ship
ecolloillists have disputed the pl1bliclll~S this list The classic textbook example of
warns all
the
evny itllll Oll
was typiCllly a
who lild not l1lY fill
next
tend to be
1Ild it
but the crux of the explanation appears (at least at first
Evell if everYOlle prdtTS having the public good to lIot having it each of us will reccive it [()l trct if S()llleOlle else pays It)r it After all the belldirs are nonexcludahle if ~lIlyone gets the
So we typically have an incentive to
pays holds back from p~lying
Thus t1w classic public good argumellt is fllr state action to fix the markets failure to generate efficient outcomes In the interests of
it is ottell said goveml11lllt Illust require everyone to
cOlltribute to the nroduction of sHch [oods While DowtTtill the
argument is not quite IS as it seelllS Three must be lIlind
For lll goods argulllent f()r sLlte action it Illust that evervone wants the lood hut that in
everyolle VlIlts the
I)r it to not hiIlg It
~ It is not the case tlut 1lllrhts lllVlT
so dlicilIltlv Suppose A1t golt wanden illtu
llls hcrvcggics lilt Blttys dog walldlls illto Ales property
his go]t 0 thlt it dOl lint gIVe 11l1lk I A [tllce would he J
ASSUllll thlt clCh would bcnefit hy would he hltln orfhllilliJllr till fellCt llolle thall lIot
tlut till other budd 1) the ()tlln
lleithlr build III meh a case SillCl lleh would prdir to pay I()r the (IHire good r1Il1er thall do virhout it the puhlic goud will be provided (lIld we sh1I1 SCl
SCttioll -+J Ollt PlOIl will pay t(lI rhl llItire good) IwviU)11 uf
do lIotlonstitlitc I llllrkct tlilurc ulltil we add ttlltlwl conditIOns such as rlLlt IJO Olle illdividuds utilitv ftlllclioll is sudl thlt It is rltiOIld tllr hllll to
leveLmiddot tilere In a Illllllhn of pl0lll (SO caell IS temptcd to
or we dn llot kllow how IlIIIlY IllOples lOOPlTllioll is
lllccssary to s((llre the good) ell As thl Illllllber ofilldIVidu11 ill(llnd IllcrlISlS the Illcd fill St)lllC sort off(l1lll11
lbollt dlocltioll of C(1lI tri hu tiolls bl(()Jlll IHCla rv
per SC but fluhlll that
lHlIllhlr ofagellts thar arc IHost Ilkllv no hy the Imrkct
) WI1lthlT puhlic good wdl he volulltlrily sllpplild alld whtthn
llllivcrsd nmtrihul()11 1S lttiulllt also deplluls 011 the nlatioll
thc goods alld individual cOlltributioll We c1l] l1htllll1I1h three hasic types of rtbtiollS
1 COlisali Rellrt1s It ( is til( totll allloullt or ill( llld ( is rhl u)lltrihutioll of allY illdividual
88 89
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
CHAPTER 3
then G G I + + + Gil Each individual adds to the amount of the
here is picking IIp aHer your in a public park each persons cOlltributioll helps secure the good of J clean park where 111 call walk vithOl1t feaL
b J11Ycslwld Ilt Ihc Ttl] If C is the totll amount of the and C is the contribution of mv
individual i then there exists some perSOJl k slIch
that C GI + + (1 + e (CI C2 + + + (1 + The cOlltrihutioll of individual k and those iho ttl110w her add nothing to the lmOllllt of
secured Suppose that ve all support a candidate fJr office lIld she needs 1O()()O signltlJreS to get 011 the ballot After she has obtained 1O()()O vil1id signatures additional signJtures do hef 110 good (It least fiolll a
do lIot help her get on the bll1ot
c nmsllOld III the Bottoili If C is the total illlJOUllt of the good produced and (j is the contribution of any individuill i thell there exists sOlne person k such that
2 + C l G 0 but (I + C 2 + (1 + C gt O Until the contlibution of indivlduJ k is no public good i achieved Again think of our
candidate until the 1OOOOth sih1li1ture is obt1inld no good i1t all is produced
We em identify both purl and mixed CISlS
that combine these types) We might have good that constant retllrns up to a top tllresllolll Nit tl1tn 110
more returns thereafier or which has a bottow threshold lIld COilmiddot
stant returns thereatter Illd so on Consider three interesting rasts (i) a simple case of constant returns (ii) 1 threshold at the bottom whefe the k person is also the II or last person 1I1d (iii) a case of cOllStant returns lip to a threshold at the top Will the good be provided each person maxi]l1izinl her own lltilitv or is sOllle sort of coordishynation or
(i) I silllple ((ISC (f WISllllit reflmls [n the case of COIltl11t returns each individual contribution seClIfe a bTelter level of the t)Ublic lood So AWs actioll seeuns some of the good he will incur some costs but since he NillltS the good he also secures some benefit fi0111 his contribution u(b) The
90
JII
EFFICIENCY
is that while Alfs p(() is the total costs of his share of producing the good his benefits tJ(b) are just a slllJII part of the total SOCIa benefits since everyone gallls trom his contribution
the good is nOllexclu(bble and nonrival) As 1 Dtionalecollolllic agent Alfstops contributing when his costs equal the marginal benefits 10 ililll But this will not adequately take account of the over]11 social
his contribution since all others will benefit tlom the
of the good be will provide This is a c1]ssic case where
will be underpnwided bv uncoordinated individual
A threshold at Ihe J01l01II IIICH Ihe k pcrsoll is also the n or IdSf
1)(Tsoli [n tbe second and very speri] case lICY)olles (Olitrihllfioll
ifill( good is to he s((fred (I lt11 All example is 1 crew ofl unless everyone rows the bOlt will not make
the strong current No public good is seclired ulliess everyolll colltributcs-tbe public good of reaching the destinatioll will not be achieved lIllless everyone does her Here in In illtcrestin( case whnc the public good is apt to he Khieved purely volulltary choices based silllply on individual utility maximization since no lIldividuill 11Is an incentive to over- or lI11dercolltrihutemiddoti
I (ISe (f(0IlSt1111 retllfllS lip to II tre~101d Ililhe top The third case is
illtaestlllg because here it is illclliciclIl to relluire everyolle to contribute all the tillle SUDDme at Alfs ColleQc there is 1 IaWIl
across from would prefer a nice lawll between the
two buildings to a shoddy Olle But evcryollc dso is inconvenicllced by having to walk all the way around the lILld
the walkways are) Each persoll would preftr having nice lawn alld cuUinl across diagonally I~the shortest route
-to having a nice lawn 1111
using the walkways If everyone Cllts leross the lawn will be
1() out of a 1O() peoplc do so there will be IlO
the threshold ~lt the top after the ()(Jth person
across the ]WI1 no rIlrther public good IS
COl1sider three policies 110 one crosses so we hlve iI beJlItifllllilwn but everyone is
1re
everyone crosses 1oX of the time The
91
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
cost As tlr lS if WC liT HOIIIO
for choosing between the
(but ifwc aSSU1lle that tlimess is part of the thml is to bc pret(rred see public IlO1iCV bJstd Oil the
EFFICIENCY CHAPTER 3
might even policy h docs) seek to ((111( 11l
frcc-riders (wIth llolicv b 1
stcond and tbird policies art Pareto illlpruvel1llnts Oil the first
Ten people can be 1Ilade better off (they (111 cut across tilt without allY additional costs to othns or tveryollc can be madt better ofF 10 of tbt time the stcond and third policics acbicvc
but at a lower
it
to ullderlnine the basic idel that uSlully
of dliciency doe Iwt necessarily seck to Clllllinlte tht hCIllfits without pping the
level of
None of this i The point is tlutthe stltc should tIX cvnyonc to secure pllblic
of sUtl IctiollWl should lw Iware that the necessity and iIlllllniilll intl-rshyto secure universal contribution is hy no IllllIlS an
thl pursuitence llOI1l the Illere existence of a puhlic good
SUMMARY
I have tried to explain the Ilotion of ettlcilIKY andIn this its rcLltion to rationality Tim ehIDter hls
bull 1)lt1111111 WII) II
ier 11I(J~~illdl rrlliolldllVllSlfllICf lIill (OlSllIlIC iI good l 0 Ihe
ltIlidl Il(r 1II1I(illltl1 ((lsls Wc hIVl a)o
scen that 1 rational producer should produce lip to the point
whert her marginal bCllefits lqud hn
1111) 111101111 (OIlSllIlIers Jlillllldk1 ((lldllg11 Illdl are Ptn1lobull illlprOIJ1lIlCllts The Edglworth Box IS expL1l1lcd
considered the rcLltioll of the contract curve to
Explaillcd tile idell of Pareto superioriry wd PUJctobull COllsidered IlilellieY tlu Pafet) prillciplc is lIililhir ltIS I IIlltlfll iilelllbull
tlH 1I0lhlll 1111 extcrnllif) 1111 ((lIsitiered IIlctl( 1111 id(albull prpcfl) 1((1111 tlwr illlcmllic 111 II( (0111 dlld hCllefls (
92
Ilriil-il) IIlakes s(I( The problclll we saw is that
lllothcr persoll negHively impacts Illy utility and this is not taken Illto ICCOtlllt ill her decision she imposes 1II nternality on
JIlL But if Illy prdirlllces 1Ie about wlut she should lIld should
not do I wdl illlpose an extcrnality Oil l1Ie simply by living her Jill 0 she secs lil This nroblt1Il of adetlllatdv ddillillg all
of the Paretu
bull Sct(J(t II( (gtOd( liI(Of(lII
bull ( olli(I((1 IIMi( yood Imil
ltlaio1l ltllId 1(li)( 0111( (llses 111(11 I 0111 II tl1 1) 11(liOIl lIil s((Ire rliClII
NOTES
Scc Anhur M (raquo)llll 111lil) 1 he
2 NlIIlCd after hlllels (1 -gt11-1 )2()) who depicted IIICfllallC
alJoclti()IlS of resource all pmslhilnics f(lf COlli nets ill this way
1 )I COllI If wc ill lIdmvlllclll dkcts (Stctioll alld Air and
a prltl-nlIcl to klC wh1I Ihcy alrtldy ILlll thcll they 11111
ILHlc We Cll] IIO l1lttlr set why llldowllll1lt dtltlIs worry
-L
he) In the very 1lllrt of
allolative from Plfer()
helHlits IS
Ut 27
socd cosl-bllllilt
93
t
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95
CHAPTER 3
1 Rmsell Hardin makes much of the in thi~ See 1m
illld SmiddotciI) Pl 10-11
of1 Pjnrian LIberal For an
extcnded and ](ccssiblc disclIssion sec Sells amI Y
10 Sell and Rights p 211i
Ibid p 21S
12 See here HllI~llI1Il and McPhersoll FCOIOllli( (IId ivora Ihilos-Pl 71i-7)
1 See DCllnis Mucller IIiMic Choicc 1lI p 25
14 Sec (lITltt Hardin The of the (Olll 11101 IS
S Sec )lvid Schl11idtz Thc LiIIIlIS (f (OIIIIIIIICIII 111 01 the IJlhlic Coods
1( John Stuart Mill OJi 4 PI[1 1
7 Ibid Chapter 4 para 14
11 Ibid Chapter 5 para J
I) Scc ROIL]ld Coase Th ProbleIll of Social Cost
tllliows Muclkr Public Choice Ill pp 27-10
20 The Coasl theorclll Jll he applied to more realistic cases wlllre
activitls have variable costs-the Illore pllrcha~c of
the extclIlalilics SCe MIIlIIl PJlbIC Choicc III
2 ibid pp 1()Il
22 has a Will not
21 But thIS i lot to say that govclIll11clltal COC1civl actlOlI is necessary Sec
J)~tvld ScilIllidtz 1U Lilllis of (WCrJllIU111
~4 Muclkr nice OVLTvicw of tlIe cxtClll III wlmh lIllhvidual 01shy
t1mary dlOins Will seClIrl public goods alld how this result III 111111ershy11IJ1i( Chicc Ill pp IlilT TIll disClISSlOIl that t(Jllows draws ()Il
this part of Mudhr
~5 Sce ibid p 22 But see the of elK tSSULlllCl III SlliOll 4 1
2( Sec David Lyolls Till FOriIS 1IIId Liltllrs ( I JrilildlidllilII PI ()I)n~ 162f1 I havc discussed this case ill mOlT dt1I1 ill Illy SonoIIlli)sopIY PI lli2f
94
4
Game Theory
OVERVIEW
I II our lXamillatioll of utility theory ill Chaptef 2 we f(KlIscd Oil ~] fatiollal agellt as olle who has prc(erellces over outcollles and a sd
of fixed adioll optiOIlS alld who elll correiatl outcollles with lctioll shy
her nrlitnlllTs Olr outCOllllS determined hCf
J wt begall to consider how rational also arc chlracterized by [he ldditionll
interact alld eSplCillly how ration11
economic agellts wil lngal in efficiellt trallsactions 13m the
of rational intLlactioll ill Chaptcr 1 tlKtiSed
moves -middotroulhlv cases in which 1llts interests
of cOI1t1ict We gallls -a glIltTll tl1lOry of what
other ratioml aglnts lI1d especially whtn wh1t is best for not be best Jr AIr In this Chlptlr I Lmploy ollly the gellnal idea of individuals as utility lllaxillJizers the specific additional features thlt
are nquirld fiJr HOIII wllollliOlS are not cClltral to this
(Again we Slt hy it is Sll illlportlllt to distmguish [01110 ftollolllims
from rltiOllal utility maximizers ill The chlpter begins with thc sllllpiest sort of gII11C a zefO-ltlI III
gamc ill which whltevlr one person villS the other lusls This is a game or pllfe ((lllt7ia We then IllOVC on to the f~l1llOUS Irisolllrs
Dilemma and other variable-sulll games -soll1e will bc f()Cuscd
on cOIlt1ict but we will also look at glI11lS in which
will cooperate It ii illlportallt to realize that
95