Efficient Allocation of Production - Essay Example

Download file to see previous pages The Coase theorem states that in the absence of transaction costs, ownership of property rights does not matter for efficiency. In other words, as long as property rights are defined and enforceable, the efficient, socially optimum outcome can be attained regardless of whether the polluter or the victim owns the right to the property. In the diagram below, the firm’s situation is depicted. The firm maximizes its profits by producing QF while the social optimum is Q*. The coase theorem states that in the absence of transaction costs, regardless of whether the firm has the right to pollute or the fishermen have the right to clean pollution-free water, as long as someone has the property right, the social optimum outcome of the firm producing Q* will be attained.

The mechanism through which this holds is shown below under the two following cases: a) the firm has the right to the property and hence can produce any amount he prefers, and b) The fishermen have the right to clean water.

In this situation, the firm will tend to produce QF since that maximizes its benefits. The total profits it gains by producing QF are given by the area of the triangle AOQF.

If the firm does produce QF the total social damage is given by the area of the quadrilateral BOQFF. However, observe that in this case if the fishermen pay the equivalent of the area of the triangle EQ*QF to produce output level Q*, then the firm will be indifferent between accepting this deal and staying at the previous level of output since the total benefits remain unchanged. The fishermen however will be better off since they save a net damage worth of the area EQFF. Thus, the output will come down to Q* which is the social optimum.

In this case, if the firm has to produce even a single unit, it will have to compensate the fishermen for the damage it causes. Similar to the earlier argument, the firm will pay the fishermen equal to the area BOQ*E and produce Q* which will leave a net benefit of area AEB for the firm. The fishermen will be indifferent between this deal and the initial outcome while the firm will strictly prefer it.

(a) An agent is said to have risk-averse preferences if a certain income is preferred over and above a fair gamble that has the same expected income. In terms of curvature, this implies a positively sloped concave utility function defined over wealth.

(b) The certainty equivalent of a risky choice is the amount of certain income that generates the same utility level as the risky choice. Typically, for a risk-averse agent the monetary value of certainty equivalent is less than the expected monetary value of the risky choice.

(c) The risk premium is the additional amount of earnings that have to be associated with the risky choice that makes the risk-averse agent bear the risk and pick the risky alternative over and above the riskless choice.

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