Trading maximizes wealth – if trading is easy

Aprender de Epi y Blas enBarrio Sesame

We Love Markets!American politicians often say “I believe in the free market

system”. Whether they know it or not, this comes from a basic economic model where trading maximizes wealth. Here we will present a simple version of this model, starring Epi y Blas.

We will then show circumstances where this does not work, and where you might want the government to intervene.

A “Market Failure”Property right: bundle of entitlement defining owners' rights, privileges,

and limitations for use of a resource

We’ll say a property right is “well defined” if the owner of a resource enjoys all the costs and benefits of using that resource.

An Externality exists when the welfare of some agent depends directly not only on his activities, but also on those under the control of another agent. This occurs when a property right is not well defined.

Note that the reason we use the word "externality" is that external costs are imposed. If you have garbage rotting in your kitchen, it’s unpleasant, but it’s not an externality. The trick for, say, a steel mill or a copper mine, from a public policy point of view, is to get them to internalize their externality.

Market Failure #2: Public GoodsDefinition: A public good is non-rivalrous and (generally) non-

exclusive.Non-rival: One consumer consuming a good does not affect

another consumer's consuming the good.Non-exclusive: People cannot be excluded from consuming the

goodExample: National defense. Consumption is non-rivalrous and

non-exclusive. We can see a clear example of market failure - private parties cannot be expected to provide the optimal level of national defense.

Another example: Over the air radio and television (except in Britain, where they hunt you down and make you pay for this right.)

Can the Market Solve an Externality Problem?Blas and Epi live together on

Sesame Street. Epi would like to count sheep in order to go to sleep. But that keeps Blas up. They have “payoffs” that look like this:

What is the best number of sheep counted?

How many will Epi count, if he does not care about Blas?

Is there anything Blas can do about it?

Sheep Counted

Epi’s Happiness(marginal)

Blas’s (Un) Happiness

Total Wealth

1 10 (10) -1 (-1) 9 (9)

2 18 (8) -3 (-2) 15 (6)

3 24(6) -7 (-4) 17 (2)

4 28 (4) -15 (-8) 13 (-4)

5 31 (3) -25 (-10) 6 (-7)

Assume Epi can choose, but Blas can pay him offThe 5th sheep is worth 3 to Epi, it

harms Blas 10. So they will reach a deal so that Blas will pay Epi somewhere between [3, 10] not to count the 5th sheep.

The 4th sheep is worth 4 to Epi, 8 to Blas. So Blas will pay Epi [4,8] not to count the 4th sheep.

The 3rd sheep is worth 6 to Epi, 4 to Blas. So no deal!

As a result, Blas will pay Epi [4+3=7, 10+8=18], and Epi will count 3 sheep, the wealth maximizing level.

Sheep Counted

Epi’s Happiness(marginal)

Blas’s Happiness

Total Wealth

1 10 (10) -1 (-1) 9 (9)

2 18 (8) -3 (-2) 15 (6)

3 24(6) -7 (-4) 17 (2)

4 28 (4) -15 (-8) 13 (-4)

5 31 (3) -25 (-10) 6 (-7)

Assume Blas chooses, but Epi can pay him offThe 1st sheep is worth 10 to Epi, it

harms Blas 1. So they will reach a deal so that Epi will pay Blas somewhere between [1, 10] to count the 1st sheep.

The 2nd sheep is worth 8 to Epi, 2 to Blas. So Epi will pay Blas [3, 8] not to count the 2nd sheep.

The 3rd sheep is worth 6 to Epi, 4 to Blas. So Epi will pay Blas [4, 6]

The 4th sheep is worth 4 to Epi, 8 to Blas. No deal!

As a result, Epi will pay Blas [1+2+4=7, 10+8+6=24], and Epi will count 3 sheep, the wealth maximizing level.

Sheep Counted

Epi’s Happiness(marginal)

Blas’s Happiness

Total Wealth

1 10 (10) -1 (-1) 9 (9)

2 18 (8) -3 (-2) 15 (6)

3 24(6) -7 (-4) 17 (2)

4 28 (4) -15 (-8) 13 (-4)

5 31 (3) -25 (-10) 6 (-7)

Solving the ExternalityYou might think Blas and Epi are a silly example

But let’s say I changed the table above to “Tons of Hideous Guck Emitted into Stream,” “Payoff to Yanacocha Mine”, “Payoff to People of Cajamarca.”

The Coase Theorem: If transactions costs are not “too high,” the market will find the optimal (best, wealth maximizing) solution.

But what constitutes “transactions costs?”

Transactions CostsWhat could be a transactions costs?1) Spite. Perhaps not so much in business, but often in divorce (“The War of the Roses” (1989))

2) Government Regulation and taxes; say a tax on trading

3) Public goods problemInstead of having only Blas being affected by the toxins in the stream, let us have

217,000 residents of Cajamarca being affected. Now fighting pollution becomes a public goods problem. (So the problem with externalities is that they create public good problems.)

Here the government could come in and impose a solution. The government could say: Don’t pollute so much; orPay us X sols every time you pollute. What is the difference?