[SOUND] We are about to discuss comparative advantages and disadvantages of markets and governments as mechanisms of resource allocation. As we have just noted, markets are based on private decision making and private ownership. Governments are public agencies and they move resources about economies by commands, by orders, by fiat. So, to what extent markets are superior or inferior to governments in this capacity as mechanisms of resource allocation? To answer this question, of course, we have to be guided by efficiency. Remember, economics is a science about wealth of nations, and wealth of nations depends on how efficiently they put in use the available resources. Before we do these comparisons, it's important for us to agree how we will be measuring efficiency of resource allocation. This is a very serious and controversial question. If we measure resource allocation from the perspective of a single individual, this is a fairly simple task. After all, we believe that individuals are rational, and that often means that they know what they want, what they like, and what they don't like. Put slightly differently and a bit more technically, individuals have preferences. And it's common for economists to describe such preferences by utility functions which assigns a number, a value to every option available to the individual. And the greater is this value, the more preferable a particular option is. And, therefore, individual choice can be, therefore, described, it can be modeled as the maximization of a utility function. So far so good, but societies are populated not by one individual but by many, by actually very many. And then the question is, of course...That would be an appropriate slide here. And then the question is, of course, how you measure efficiency in the presence of many decision makers, in the presence of many agents that, perhaps, have different views on what is good, what is not, what is efficient, what is not, and so forth. A general and powerful answer to this question was given by a renowned economist and sociologist by the name of Vilfredo Pareto. Pareto introduced the concept of what is now known as Pareto-dominance and Pareto-optimality. Suppose you have two options and several individuals which compare these options. If some individuals think that option A is better than option B, and none believe that option B is better than option A, then we would say that option A is Pareto-preferred to option B because it's preferred by some people and none opposed of that. So other people are, perhaps, indifferent between these two options. Quite obviously, if all people agree that A is better than B, then, of course, it's even more, so to say, Pareto superior to option B. And, therefore, an efficient outcome, an efficient version of resource allocation would be the one which is Pareto-optimal. Pareto-optimum is an option or a resource allocation such that there is no other way to reallocate resources that would entail in allocation that would be Pareto superior, or Pareto preferable to the given one. So, to conclude we would say that resource allocation is optimal not just from an individual point of view but from the social point of view if it is Pareto-optimal. And now a very big and very important question. Suppose you have a market economy, suppose this is an uncontrolled, unregulated market economy, completely free willing, what they call Laissez-faire market economy. And in this economy you have a community of individuals. And every individual makes individual choices, and these choices are optimal for this individual. But no one is concerned and, for that matter, in charge of a social optimality. Can we expect that such combination of individual choices will be socially optimal, will be Pareto optimal? And against all the odds, the answer in some circumstances is "yes". And this answer is given by the famous first theorem of welfare economics. This is more rigorous formulation essentially of the metaphor of the invisible hand introduced first by Adam Smith who was amazed by reflecting upon what many people took for granted that is that market forces are able to maintain harmony in societies and economies when no one is in charge of allocating resources across the economy and across society. All decisions are individual, all decisions are private, all decisions are seemingly uncorrelated, and... I'm sorry... all decisions are uncoordinated with each other. And nonetheless, you have an outcome which is not just an equilibrium but apparently a very efficient equilibrium which entails the best possible use of the resources available to the society. And this is precisely what the first theorem of welfare economics is all about. It states that market equilibria are Pareto-efficient. Market equilibria which are outcomes of individual self-seeking behavior, in fact, entail efficient allocation of resources in the economy and society. However, this great result is contingent on some requirements, on some conditions. It's not true universally. And, perhaps, the most essential of these conditions is that all transactions in an economy for the first theorem to hold have to be supported by competitive markets. In other words, whatever people do in this economy should involve competitive markets and for every commodity, for every transaction, for every interaction there should be a competitive market at hand. And, of course, we all know that this is not the case in our lives, so this is an exaggeration. In real life markets are either not competitive, or worse yet, they simply do not exist. And in such cases we have reasons to doubt whether the market equilibrium would be Pareto efficient. And, of course, many of you who have taken at least some courses in economics know what i am talking about. I am talking about externalities. Externalities occur every time when interactions between economic agents are not supported by markets. They arise when my decisions affect you, but there are no market transactions to support this influence. And the way my decisions affect you could be beneficial for you or could be harmful for you. In the first case, not only I myself benefit from my decisions, which is arguably my main rationale to take these decisions, but you too. But unless I am a very pro-social person or altruistic person, I don't care about you benefiting from my decision, I am concerned about my own gains. Or, perhaps, worse yet, my decisions have affect in a negative way. You incur losses as a result of my actions. But again, this is someone else's losses, and, as a result, I do not take these losses into account when I make my own decision. Externalities about us abound. Environmental degradation is, perhaps, the best-known kind of externalities. If several people, for example, several fishery companies, use the same stock of fish, they certainly influence each other and influence each other in negative way. And this is what is known, as you might have heard, as the tragedy of the commons. When I use my car to drive across a city I meet a rush hour, then of course I create externalities because the presence of my car contributes to traffic jams. You can continue these examples on and on. One common feature of externalities is that if externalities remain uncontrolled, unregulated, uncoordinated, such externalities cause efficiency losses. Why is that the case? Think about that. If decisions are entirely private, and at the same time if consequences of these decisions do not affect anyone but the decision maker, then these decisions are almost by default optimal because the person who takes these decisions includes in his calculations, implicit or explicit, all of the gains and all of the costs. He is the only one who benefits from the gains. He is the only one who accrues the costs, and, therefore, he maximizes his net results and, as I said, as a result, decisions are optimal. Now, if at least a portion of the gains is felt not only by the decision maker but by someone else, or if at least a portion of the costs, or maybe entire costs are borne not by the decision maker but by someone else, then social optimality, social rationality become separated, divorced from the private one. There is a wedge between what is good for the society and what is good for an individual. Because individual in her calculations does not take in full account all of the costs and all the benefits. Have a look at this picture on the right-hand side of this slide. This is an example of an externality. Along the horizontal axis we measure the scope of certain activity, I should say the scale, of a certain activity [SOUND], for simplicity sake, a volume of production of a certain good. Along the vertical axis, let's measure costs and benefits. The top curve shows the benefits as a function of the volume. And for simplicity sake, let's assume that these benefits are captured entirely by the decision maker, say by a producer that runs this business. The producer bears only a portion of this total costs, and the rest of this total cost is borne by someone else, by the victims of externality. And then if this externality is left unregulated, the producer will not be concerned about a portion of this cost, about the difference between these two curves. Now lets look about the costs. First of all, lets talk about the full costs that are resulting from this activity. The curve that describes how the full cost depend on this activity is the top curve, and what is socially optimal is the activity level where the net gains, which is the difference between the benefits and the cost, is maximal. So, this is social optimum. Anything less than social optimum, any activity level, which is less than socially optimal, would diminish the net social gains if it's above what is socially optimal, and then the efficiency gains would be smaller as well. And beyond this point the net efficiency gains would be negative and, therefore, such activity would be completely wasteful to the society. So, if decisions are made in the social interest, the optimal decision would be right here. Suppose now, however, that a portion of the total cost is borne by the producer, and this is the lower curve. And a portion is borne by someone else. And this is the difference between the total cost and the portion of the cost which is borne by the producer. The balance in this difference in costs is borne by the victims of the externality which is involved here. And, as a result, the producer does not care about this gap between these two curves. The only thing that he takes into account directly, of course, provided that the externality is left unregulated, is his own cost. And that certainly effects in a very dramatic way his calculations of costs and benefits. Now, what is optimal for the producer is the activity level, the production level which maximizes the difference between the gross benefits and his own costs. And this optimal production level is way higher than what is socially optimal. Therefore, from his personal point of view the producer behaves optimally. From the social point of view he overproduces. And although, as a result, his personal profit considerably increases in comparison to the social optimum, the social gains decrease, they become much smaller here at the social gains where the decision, the individual private decision by the producer is made. And you can see that they're way smaller than what is optimal for the society. In fact, one can easily imagine a situation when what is optimal for the producer is actually something that entails negative net gains for the society. So, that's, that's a clear example, clear illustration of an externality, and quite obviously in the case of externality here you see a loss of efficiency. Private decision is not social optimal. So, it might be worthwhile to ask to what extent this difference, this gap, this separation between what is individually rational and socially optimal, to what extent it is typical, to what extent, perhaps, it's just, you know, a happy accident. And the answer is that it's very common and very usual that a combination of social optima, if people interact with each other without using markets, is not Pareto-efficient. And, in fact, it's a very rare exception that a combination of social optima is Pareto efficient. And the best way to illustrate this simple point, and that's quite important to keep in mind if you want to really appreciate the role of government in modern economies, is to use simple models, simple concept of what is an outcome of individually made rational decisions, and this is that the concept of the Nash equilibrium. Suppose you have several individuals, several decision makers. Each one makes a certain decision and people are affecting each other, so that my preferences, my well being, my utility depends on decisions taken by someone else. What is a Nash equilibrium? Everybody makes their own decision, and in a Nash equilibrium my decision is my best response to the decisions of other agents. I cannot control decisions of other agents. They are beyond my control, but I am aware of these decisions, and I am trying to respond as best as possible to these decisions, and so does everyone else. So, in a Nash equilibrium no one has an incentive to deviate from her personal choice given the choice of other individuals. So, this decisions are individually optimal. Are they social optimal? Are they Pareto-optimal? Well, no they aren't. And they are not optimal by Pareto as much as on the possible, and let me explain why. Have a look at this illustration. Suppose that we measure the decision variable of the first individual along the horizontal axis, that is so to say x1. Suppose we measure the decision of the second individual along the vertical axis. And this is, so to say, x2. And each individual has utility function which depends both on x1 and x2. Utility function of the first individual depends on his own choice but it also depends on the choice of the other individual. And I will make my choice to maximize my utility but I am aware that my choice is also affected by the choice of another person and vice-versa. So, what is a Nash equilibrium? Suppose that the second individual has made up her mind and has made her choice at this point. As a result, what is available for me is, so to say a budget line, is this horizontal line, and I maximize my preferences along this horizontal line, and my outcome of this maximization is this point because at this point my indifference curve, is tangent to the budget line. The same thing is true about the second individual. He reacts on my choice if I am the first individual, and my choice is x1. So, his area of choice is this vertical line, and this is his budget line, and on this budget line he has to choose the best possible outcome. And, of course, in the best possible outcome his indifference curve has to be tangent to the budget line as well. So, this is the outcome. This is a Nash equilibrium. Is it Pareto-efficient? No, no, because if an allocation is Pareto-efficient then, as you probably know, indifference curves have to be tangent to each other. Here, they are not tangent. They are perpendicular, and nothing can be further away from being tangent, than being perpendicular. So, there is no way that this could be Pareto-optimal. And, in fact, this allocation between these indifferent curves, as you can see, is superior for both individuals. So, if there were a chance for these two individuals to move from this point to this point, both of them would have been better off as a result. Trouble is, this Pareto-superior allocation, cannot be supported by private decision-making. It requires some coordination, and individuals are unable to achieve this coordination on their own. Well, it might not be as gloomy because what would be kind of natural expected reaction to this, quite obvious – the market failure – because private decisions fail to achieve an efficient outcome, would be okay. Let's invite government. Let some agency that will coordinate these individuals and will force them to make decisions that would take them away from the Nash equilibrium and will put them here, and, as a result, both of them will be better off. And they will be applauding such an agency and will be grateful to it for being, for helping them to resolve this coordination problem. But there might be private alternatives. So, do not rush to invite government because, you know, governments can cause considerable damage to the economy and people, of course, has suspect of government, often say, if there is a chance to achieve a private resolution of this market failure, and according to Ronald Coase, there is such possibility. Ronald Coase, of course, is a renowned american economist just recently passed away in a very advanced age who made himself famous among other things by spelling out the so-called Coase theorem. The amazing thing about the Coase theorem is that this is, perhaps, the most popular concept of modern economics. And not just economics but a number of adjacent social sciences. If you google Coase theorem, then you'll probably realize that it's the most popular hashtag in old vocabulary of economist. And at the same time, the Coarse theorem is actually a very simple statement. It's almost trivial, and it says that rational individuals through negotiations will always be able (this is missed on the slide, unfortunately) to make the best use of available resources, i.e. to reach Pareto-optimality. Coase Theorem places hope on negotiations. We've reached a private solution. Let's get back to this picture and realize that this private solution is not the best thing that we can do. Individually, unilateral we cannot improve this solution, it requires a collective action. By agreement, by collective action, both of us conclude that the first agent in fact has to make his choice not at this point but at this point, and the second agent has to reciprocate and make his choice not at this point but at this point. And, as a result, both of them will be better off. This is a private solution. This is a private solution because individuals reach this improvement upon themselves. No one forces them, no one helps them. It's because the rational decision making, again. The Coarse theorem, perhaps, so powerful and so influential because it extends the idea of rationality from individuals to groups, to collectives. If not just individuals but groups can be collective, if they can be reasonable, if they can be trustworthy, if they can communicate, negotiate, and can stick to agreements that they have reached, then you don't need the government because individuals through these private solutions can reach Pareto-optimality. Of course, it doesn't happen all the time. And sadly it doesn't happen most of the time. Why? Because there is one important qualification for the Coase Theorem, and this one is the transaction costs. In other words, the cost involved to negotiate an agreement, to enforce this agreement, to make sure that no one sharks from the obligation that this person has taken upon himself, that this transaction costs are reasonable, they are not too high. In fact, often time, the cost of negotiating, finding agreement and implementing, enforcing this agreement could be very high, could be in fact prohibitively high. And in this case, the Coase theorem offers no remedy. And indeed transaction costs could be very high, especially when the number of involved individuals is high. Imagine the situation when there are, simply two, three, maybe a handful of people that are involved in a potential market fail. They know each other, they trust each other. They can argue with each other. They talk to each other a little bit, and they come to an agreement in this case, yes. The Coase theorem reigns supreme. There is no need to be involved in what happens among these people. However, imagine that there is thousand or thousands of people, there are ten thousands of people, there are millions of people. They have to agree to act collectively and to reach an outcome which is provided for by the Coase theorem. And it's quite obvious, this negotiation is very likely to fail. And, as a result, transaction costs are very high, and private solutions are simply impossible. Let's talk a little bit later about what are the failures of this collective action, especially if the number of people is large as it is commonly the case in modern societies and modern economies. [SOUND]
