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Jean-Marc Robin
Sciences Po
Recap
1 Introduction
2 Pareto efficiency
4 Kaldor-Hicks efficiency
6 Conclusion
Pareto improvements
Definition
A Pareto improvement is any change to the economy which leaves
1 everyone at least as well off
2 someone strictly better off
Example:
You prefer $3,500 to your car
I prefer your car to $3,500
Me buying your car for $3,500 is a Pareto improvement.
Pareto improvements are “win-win”.
Pareto dominance
Definition
Alternative a Pareto dominates alternative b (or is a Pareto
improvement) if:
1 Everybody weakly prefers a to b: ∀i, a i b.
2 A least one individual strictly prefers a to b: ∃i0 such that a ≻i0 b.
Notation: ∀: “for all”, ∃: “there exists”, ∃!: “there exists only one”.
These symbols are called quantifiers.
Example
Pareto efficiency
Definition
An alternative a is Pareto efficient if no alternative b Pareto dominates
a.
Outline
1 Introduction
2 Pareto efficiency
4 Kaldor-Hicks efficiency
6 Conclusion
Willingness to pay
Money transfers
Ui (x, ti ) = vi (x) − ti
Hence you are willing to pay up to, but no more than, v(a) to get
the ticket.
Social value
Domain restrictions
Theorem
The utilitarian choice is Pareto efficient with monetary transfers.
This is positive for those who prefer x to y and negative for others.
Outline
1 Introduction
2 Pareto efficiency
4 Kaldor-Hicks efficiency
6 Conclusion
Kaldor-Hicks improvements
Kaldor-Hicks efficiency
Kaldor-Hicks efficiency
Outline
1 Introduction
2 Pareto efficiency
4 Kaldor-Hicks efficiency
6 Conclusion
Bargaining problem
If I don’t buy the car (status quo) we get our threat points:
me, $10,000
you, $3,000
Combined payoffs: $10, 000 + $3, 000 = $13, 000
If I buy the car at some price P:
Me: $10, 000 + $4, 000 − P
You: P
Combined: $14,000
How much do we gain by cooperating:
$14, 000 − $13, 000 = $1, 000
Bargaining solution(s)
The rancher’s cattle will occasionally stray onto the farmer’s land and
damage some of the crops
If it’s cheaper for the farmer to protect his crop than for the
rancher to control his cattle
Under open range, the farmer will build a fence
Under closed range, the rancher can pay the farmer to build a fence
If a smaller herd is more efficient, the farmer can pay the rancher to
keep fewer cattle.
Coase:
Whatever is the efficient combination of cattle, crop, fences etc.
...farmer and rancher will negotiate to that efficient combination
regardless of which law is in place
...as long as the rights are well defined and tradable and there are no
transaction costs.
Three possibilities:
Rancher builds fence around cattle, costs $400
Farmer builds fence around crop, costs $200
Do nothing and live with damage
If expected crop damage is $100
Open range: farmer does nothing and lives with damage
Closed range: rancher does nothing and pays for damage
If expected crop damage is $500
Open range: farmer builds a fence.
Closed Range: rancher pays farmer to build a fence.
Whatever the Law, the outcome is the same (status quo or a fence
is built around the farm).
However, payoffs differ as the Law will determine different ways of
sharing the gains of trade.
Conclusion