The Coase Theorem and the First Welfare Theorem

Theme of the Lecture: when can institutions not improve efficiency? When can we not improve upon market outcomes?

Coase Theorem: Efficiency and Bargaining -- closely related to value maximization.

First Welfare Theorem: Efficiency and the Price Mechanism -- using prices to coordinate economic activity.

Coase Theorem: If bargaining is costless and there are no wealth effects, the outcome of bargaining/contracting is a) independent of initial assignment of ownership or property rights and b) determined solely by efficiency.

What happens is that rights are traded via bargaining process.

Why does this work? Same logic as value maximization.

Suppose we are not at an efficient point. Then it is always in someone's interest to propose an efficient point, and describe how to get there in a way that leaves everybody at least as well off.

Bargaining: Negotiation between two or more parties about the terms of possible cooperation (which may involve trade, employment, joint business ventures, etc)

Bargaining mechanism: Individuals get together and negotiate the terms of trade. Not given prices. Individuals may have negotiating power, and do not buy and sell rights taking prices as given. Markets for these rights and assets need not be competitive.

Relationship to contexts you already know:

Suppose the right in question is the right to pollute. Then no matter who you initially assign the right to, there will be an efficient amount of pollution if transaction costs equal zero and there are no wealth effects. (Initial assignment does affect distribution of wealth, though...)

Suppose in a two person firm, the question is who should be the president -- the individual with control over the long-run decisions made by the firm. Then no matter who you initially assign to be president, bargaining between the parties will result in the efficient personnel choice.

If initially an inefficient organizational form, someone has the incentive to propose the efficient one in a way that makes each individual better off.

Why doesn't the Coase Thm apply under wealth effects?

Consider ticket example from previous lecture..

I am deciding how to allocate a single box seat and single upper deck seat between Harold (from last time) and Ben. Recall Harold's preferences:

• U(B,x-10) > U(U,x)
• U(U,x+10) > U(B,x)

Suppose Ben has the same preferences, and that each has the same amount of wealth, x.

Coase thm says that the initial allocation will not affect who ends up with which ticket.

Suppose I give the UD to Harold and box to Ben.

Is this efficient allocation?

• No. Harold prefers spending $10 to obtain the box. Ben prefers receiving $10 to obtain the UD.

They trade. Assume that the trade takes place for a price of $10. Now Harold has the box seat and x-$10; Ben has the UD and x+$10.

Is this efficient?

• Yes. To make Harold better off, you would have to pay him more than $10 plus the upper deck ticket. But Ben is unwilling to pay even $10 for the box. So Harold sits in the box, and Ben sits in the upper deck.

Suppose I give the UD to Ben and the box to Harold.

Is this an efficient allocation?

• No. Ben prefers spending $10 to obtain the box. Harold prefers receiving $10 to obtain the UD.

They trade.

Is this efficient?

• Yes, by same logic as above. Ben sits in the box, and Harold in the UD.

Initial assignment affected which was the efficient allocation (a violation of the Coase Thm), because of wealth effects.

In Coase's world, there are no firms per se. Just a lot of individuals trading (costlessly!) rights over assets and decisions.

For institutions such as firms to be more efficient than individuals bargaining, you need:

• wealth effects, or
• transaction/bargaining/marketing costs, or
• ill-defined or -enforced property rights.

Fits in with the article you will read next time. Think about the role of transaction costs in the economy, both when individuals bargain and when they participate in competitive markets.

First Welfare Theorem

Short version: Every competitive equilibrium is efficient.

So what is a competitive equilibrium?

A set of:

• consumption plans,
• production plans, and
• prices

which are feasible, and such that individuals maximize utility, firms maximize profits, and markets clear (S=D).

Self-interested individuals process information in a completely decentralized way, using only their knowledge of prices.

What do firms look like in the model?

One answer: they don't look like anything. In neoclassical models firms are simply assumed to exist. Does not specify what is inside the black box. Characterized by their production plans (cost curves, feasible sets, etc.)

Firms are anything that takes inputs and turns them into outputs.

This theorem provides conditions where the price mechanism is necessarily more efficient than non-price coordination.

Under these conditions, informational value of organizations does not exist. Prices guide consumers' and firms' decisions such that efficiency is attained.

Recall that in the GM example, advantages to its organizational form was in part informational -- supporting the production and management decisions of senior executives at the company-wide and divisional level.

Companies such as McD's, Burger King, etc. own a fraction of their stores. One explanation they give is that is provides them a way to gain information about the market that they otherwise would not be able to get from franchisees. They can, for example, try out new products easier and get a quick read on demand. Under the conditions of the FWT, prices provide all the information necessary to guide firms' decision wrt what product to produce.

Coordination failures do not impede efficiency.

Recall that we said that it might be efficient for AT&T to produce different types of equipment because separate firms might produce incompatible products. This doesn't happen here. Prices guide firms to produce the efficient amount of each possible product.

Pursuit of self-interest by firms and consumers leads to efficiency.

We will come across some examples in this course where pursuit of self-interest leads to an organizational reponse. For example, a firm may vertically integrate rather than pay a monopoly price for an input. Or to avoid losing the value of specific investments. Scope of firm can be different when these conditions do not hold. Organizational responses more efficient than the price mechanism.

We will see circumstances later in this course where the price mechanism is supplanted by an organizational solution that relies on other means to coordinate economic activity. The circumstances must have foundations in some violation of the FWT.

At first glance, it appears that the assumptions of the FWT might be easily satisfied. This is most certainly not the case, because the assumptions imply further conditions that are very unlikely to hold.

For example, the "background assumptions" include:

• All markets exist for all possible goods. Indexed for time and place. Market exists for ice cream in the Mojave Desert on 1/1/2000.
• All of these markets are perfectly competitive. Firms and consumers have no power over prices.
• Every individual in the economy knows prices for each good. No search costs.

When these conditions (and a lot more) hold, prices coordinate economic activity in such a way that efficiency is obtained.

Note that you don't need the no wealth effects assumption.

This discussion moves us forward toward investigating a number of interesting questions.

• Why don't prices and markets coordinate activities within firms? (or do they, but in an unfamiliar context?)
• Why don't we see bargaining within firms to determine efficiency? (or do we?)
• How might transaction costs affect matters, and what are the nature of these costs?
• Why do institutions other than the market guide economic activity?
• When might other institutions be more efficient?

In sum:

• Coase: under what circumstances will efficiency be attained if prices are set through bargaining?

• FWT: under what conditions does reliance on the price mechanism give rise to efficient outcomes? What must not hold for non-price coordination to be efficiency-enhancing?