Chapter 18
Asymmetric Information, The Rules
of the Game, and Externalities
18.1
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Externalities and
The Coase Theorem
 When
someone’s behaviour increases or
decreases another’s utility or profit, we
say that the agent is imposing an
externality (positive or negative) on the
person affected.
 Property rights refer to the legally
established titles to ownership, use and
disposal of factors of production and
goods and services.
18.2
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The Coase Theorem Part 1:
When information is free, the
allocation of resources is independent
of the distribution of property rights,
and the allocation is Pareto-optimal.
18.3
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Information Costs, Transaction
Costs, and Property Rights
 Economic
property consists of the
ability to exercise choices freely.
 Transaction costs are the costs of
establishing and maintaining
property rights.
18.4
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Information Costs, Transaction
Costs, and Property rights
If transaction costs are zero, then
economic property rights are complete,
wealth is maximized and the Coase
Theorem holds.
 If transaction costs are positive and
significant, then property rights will be
incomplete, the Coase Theorem will not
hold.
 If Transaction costs are so large that
property rights are absent, we have a
world of anarchy.

18.5
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Externalities with Positive
Transaction Costs
 The
farmer chooses the amount of grain to
plant that maximizes his profits, assuming
the rancher will run a given number of
cattle.
 The rancher decides how many cattle to
run to maximize his profits, assuming the
farmer will plant a certain amount of grain.
18.6
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Externalities with Positive
Transaction Costs
A
farmer and a rancher can both
make use the same land because
there is no fence.
 The more cattle there are, the lower
the profit of the farmer (cattle eat
the farmer’s grain) and the more
wheat that is grown, the higher the
profits of the rancher (the cattle are
well fed).
18.7
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Figure 18.1 The rancher-farmer externality
18.8
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From Figure 18.1
In Figure 18.1 a), as indicated by the arrows,
profits to the rancher are increasing as the
amount of wheat increases.
 In Figure 18.1b) The more cattle there are
the lower profits are for the farmer, the
farmers profits increase to the left of point A.

18.9
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From Figure 18.1
In part c) point A is the Nash equilibrium,
as C* is the best output given the farmer
is producing W* and W* is the best output
given that the rancher is producing C*.
 Point A is not Pareto-optimal since both
the rancher and farmer can earn greater
profits by producing in the shaded region
(more wheat and less cattle).

18.10
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Responses to Externalities
 When
externalities are positive
resources are underallocated.
 When externalities are negative,
resources are overallocated.
 When there is an externality, there is
always a opportunity to try and avoid
it and increase the gains from trade.
18.11
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Assigning Property Rights
Transaction costs would have to be
reduced in order to deal with the
externalities and reach the Pareto-optimal
outcome.
 If property rights were assigned to the
rancher, the outcome would be at point A
in Figure 18.1.
 If property rights were assigned to the
farmer, the outcome with no bargaining
would be at point F in Figure 18.1b)

18.12
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Responses to Externalities
With the assignment of property rights
and no bargaining, the outcomes tend to
be extreme and we end up with either too
many or too few cattle.
 The assignment of property rights to the
right party does not eliminate the
externality but maximizes the gains from
trade in light of the externality.

18.13
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Responses to Externalities
The assignment of property rights is most
effective when it is well known who
commits the externality. In such cases the
damages are well known and bargaining
can take place.
 The assignment of property rights
enhances the wealth of some parties while
lowering that of others.

18.14
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Responses to Externalities
Internalization is a process in which a third
party, seeing an opportunity to make a private
gain intervenes between the source(s) and the
recipient(s) (Smoking/non-smoking hotel
rooms).
 When problems are not privately resolved,
governments may impose public regulation,
based on cost-benefit analysis, or it may take
no action at all.

18.15
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Figure 18.2 The costs and benefits of smoking
18.16
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Nonintervention
Because regulation itself uses up
resources, including gathering information
costs, administration and enforcement,
the best policy may be to do nothing.
 Coase Theorem Part 2:
When transaction costs are prohibitive,
economic activities are organized to
maximize gains from trade net of
transaction costs.

18.17
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Public Goods

1.
2.
Public goods can be characterized by:
Non-rivalrous-the good/service can be
consumed by a number of persons
simultaneously.
Non-excludable-meaning that denial of
access to the good or service is not
possible or very costly.
18.18
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Pure Public Goods
 Goods
that are both completely nonrivalrous and non-excludable are
called pure public goods.
 They tend to be produced by some
public authority rather than by profitseeking firms because firms find it
costly to enforce contracts for nonexcludable goods.
18.19
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Figure 18.3 The private provision of a public good
18.20
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Figure 18.4 Provision of a pure public good
18.21
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Asymmetric Information and
Revealed Preference
Implementing cost-benefit analysis to
public goods can be difficult because of
asymmetric information.
 The problem is that individual citizens may
have private incentives not to reveal their
actual preferences for public goods.
 Citizens may understate or overstate their
actual values of a public good, depending
on the incentives/implications of doing so.

18.22
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