Quasilinear Preferences and the Coase Theorem

We argued above that as long as property rights were well defined, trade between agents would result in an efficient allocation of the externality. In general, the amount of the externality that will be generated in the efficient solution will depend on the assignment of property rights. In the case of the two roommates, the amount of smoke generated will depend on whether the smoker has the property rights or the nonsmoker has them.

QUASILINEAR PREFERENCES AND THE COASE THEOREM 631

But there is a special case where the outcome of the externality is independent of the assignment of property rights. If the agents5 preferences are quasilinear, then every efficient solution must have the same amount of the externality.

This case is illustrated in Figure 34.2 for the Edgeworth box case of the smoker versus the nonsmoker. Since the indifference curves are all horizontal translates of each other, the locus of mutual tangencies—the set of Pareto efficient allocations—will be a horizontal line. This means that the amount of smoke is the same in every Pareto efficient allocation; only the dollar amounts held by the agents differ across the efficient allocations.

SMOKE

Person A

A's indifference curves

Person B

A's indifference curves

Contact Curve Horizontal Edgeworth Box

Pareto efficient allocations

B's indifference curves

MONEY

Pareto efficient allocations

B's indifference curves

MONEY

Quasilinear preferences and the Coase theorem. If each consumer's preferences are quasilinear, so that they are all horizontal translates of each other, the set of Pareto efficient allocations will be a horizontal line. Thus there will be a unique amount of the externality, in this case smoke, at each Pareto efficient allocation.

The result that under certain conditions the efficient amount of the good involved in the externality is independent of the distribution of property rights is sometimes known as the Coase Theorem. However, it should be emphasized just how special these conditions are. The quasilinear preference assumption implies that the demands for the good causing the exter-

nality doesn't depend on the distribution of income. Therefore a reallocation of endowments doesn't affect the efficient amount of the externalities. This is sometimes expressed by saying that the Coase theorem is valid if there are no "income effects."1

In this case, the Pareto efficient allocations will involve a unique amount of the externality being generated. The different Pareto efficient allocations will involve different amounts of money being held by the consumers; but the amount of the externality—the amount of smoke—will be independent of the distribution of wealth.

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