Graduate Thesis Or Dissertation
 

Liability rules, transactions costs and optimum externality

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  • Economic theorists have proposed that the problems created by a Pareto-relevant externality may be solved by market transactions between the involved parties. These market transactions would allow realization of the potential gains from trade which characterize a Pareto-relevant externality. After all potential gains from trade had been realized, a Pareto-efficient solution would, have been achieved. From the literature which has developed in the field, it is possible to distill two propositions which are here called the Weak and the Strong Coasian Hypotheses on Optimum Externality. These Hypotheses require certain assumptions: perfect competition in the markets for all factors and commodities; perfect information in a context of static certainty; secure and well defined property rights for all factors and commodities; and a well defined set of liability rules to serve as a starting point, or status quo point, for negotiations. The Weak Hypothesis states that "(m)arket transactions between individuals or firms involved in an externality situation will result in achievement of a Pareto-efficient solution, regardless of the initial liability rule." The Strong Hypothesis includes the Weak Hypothesis and adds that "(e)xactly the same equilibrium output of externality will be produced, regardless of the status quo liability rule." These Hypotheses are deductively tested, with the aid of simple mathematical models, for several different types of externality situations involving: producers only, consumers only and both producers and consumers; transactions costs equal to zero, and transactions costs greater than zero. For this deductive testing, the static perfect competition framework used in the original papers is retained. It is found that the Strong Hypothesis must be rejected for all cases except that where no consumers are involved, in the externality situation and variable transactions costs are zero. It is argued that situations meeting these criteria are most uncommon in practice, and so the Strong Hypothesis must be rejected for most practical situations. The Weak Hypothesis is not rejected, provided that all of the assumptions (including the crucial assumption of perfect competition in all relevant markets) are met. In situations where the Strong Hypothesis is rejected but the Weak Hypothesis is not, the equilibrium output of externality is different, under each different status quo liability rule. In this case, the selection of a status quo point can greatly affect the equilibrium output of externality, the distribution of income among involved parties and, if the status quo rule has wide application throughout the economy, the values of many other variables such as relative and absolute prices, aggregate consumption, production and investment and real income. Attention is drawn to the role of transactions costs in determining whether a solution can be obtained through market transactions between the involved parties. As the amount of variable transactions costs increases, the disparity between the solutions achieved under different status quo rules increases. Transactions costs are also likely to be greater than zero when some extra-market institutional framework is used to handle externality situations. It is argued that the size.and shape of the transactions cost curve under different institutions is an important variable to consider in institutional choice. Some directions for empirical research into the transactions cost curves are suggested.
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