[NOISE]. [ SOUND].

We are about to discuss comparative advantages and disadvantages of markets and governments, as mechanisms of resource allocation, as we have just notated markets are, based on private decision making and private ownership. Governments have public agencies and they move resources, about economies by commands, by orders, by, here. So, to what extent, markets are, superior or inferior to governments? In this capacity as mechanisms. Of resource allocation. To answer this question, of course, we have to be guided by efficiency. Remember economics is a science about wealth of nations, and wealth of nations depends on how efficiently, they are put in use, the above resources. Before I do these comparisons, it's important for us to agree how we build the measuring. Efficiency of resource allocation. This is a very serious and con, controversial question. If we measure resource allocation, from the perspective of a single individual this is a fairly simple task. After all, we believe that individuals are rational, and that often means that they know what they want, what they like and what they don't like. Put slightly differently and a bit more technically, individuals have, preferences. And, it's common for economists to describe such preferences by utility functions, which assigns a number, a value to every option available to the individual. And the greater is really, the more preferable a particular option is and therefore individual can be, therefore, described that real model, as the maximization of a utility function. So far so good, but societies are populated not by one individual, but by many, by absolutely very many. And then the question is of course, that the inappropriate slide here. And then, the question is, of course, how you measure efficiency, in

the presence of many, decision makers, in the presence of many agents. That, perhaps have different views on what is good, what is efficient, what is not and so forth. A general impoetant answer to this question was given by a renowned economist and sociologist uh,by the name, Alfredo Pareto. Pareto introduce the concept of what is now known as, Pareto-dominance and Pareto-optimality. Suppose you have two options and several individuals which compare these options. If some individuals, think that option A is better than, option B and, none believe that option B is better than option A. Then we would say that option B is, Pareto-preferered, to option B, because it's preferred by some people and not opposed of that, so other people perhaps indifferent, between these two options, quite obviously, four people agree that, A is better than B, it's even more, so to say, Pareto superior to option B. And therefor, a efficient outcome, an efficient version of resource locations would be the one which is, Pareto-optimal. Pareto-optimal is, options or a resource location. Such that, there is no other, way to reallocate resources, that would entail in our location that would be, Pareto superior, or rather preferable to the given one. So to conclude we would say that, resource location is, optimal. Not just from an individual point of view, but from the social point of view, if it is Pareto-optimal. And now a very bigger and important question. Suppose you have a market economy, suppose this is an uncontrolled, unregulated market economy, completely free of ruling. What they call, Laissez-faire, market economy. And in this economy, have a community of individuals. And, every individual makes individual choices and these choices are optimal, for this individual. [SOUND] But no one is, concerned [COUGH] and

for that matter in charge, of a social optimality. Can we expect, can we expect, that such combination. Of individual choices, will be, social optimal, will be, Pareto optimal. And against all the odds, the answer in some circumstances is yes, and this answer is given by the famous, first [COUGH] theorem of welfare economics. This is more rigorous formulation essentially, of the metaphor of the invisible hand, introduced first by, Adam Smith. Who was amazed by reflecting [INAUDIBLE], by reflecting upon what many people too for granted. That is the market forces are able. To maintain harmony, in societies and economies when no one, is in charge of allocating resources across the economies and across society. All decisions are individual, all decisions are private. All decisions are, seemingly uncorrelated and, I'm sorry, all decisions are, uncoordinated with each other. And none the less, you have an outcome, which is not just an equilibrium, but apparently a very efficient equilibrium. Which entails, the best possible use, of the resources available to, the society,. And this is precisely what, the first theorem about Reaganomics is. It's all about, it states that market equilibria are inefficient, market equilibria which are outcomes. Of individual, self-seeking behavior in fact, entail efficient allocation of resources in the economy, and society. However, this, great result is contingent on some requirements, some conditions, it's not true universally. And perhaps the most essential of, these conditions is that, all transactions in an economy for the first theorem to hold, have to be supported by competitive markets, in other words whatever people are doing in this economy should involve competitive markets and for every commodity, for every transaction, for every interaction. There should be a competitive market at hand.

And, of course, we all know that, this is not the case in our lives, so this is an exaggeration. In real life markets are either not competitive, or worse yet, they simply do not exist. And, in such cases we have reasons to doubt, whether the market equilibrium. Would be, Pareto efficient. And of course, many of you have taken [COUGH] at least some courses. And you can almost know what i am talking about. I am talking about, Externalities. Externalities occur, every time when, interaction between economic agents. Are not supported, by markets. They, arise when my decisions affect you, but there are the market transactions, to support, this influence. [SOUND] And the way my decisions affect you, could be beneficial to you or could be harmful for you. In the first case, not only, I myself, benefit from my decisions, which is arguably my main rationale, to take these decisions, but you too. But, unless I am, a very pro-social person or altruistic person, I don't care about your. Benefiting from my decision, I am concerned but then my own gains or, perhaps [UNKNOWN] my decisions have affect in a negative way you incur losses as a result of my actions. But again, this is someone else's losses, and a result, I do not take, these losses into account when I make. My own decision. Externality is about us, abound. Environmental degradation is perhaps the best-known of externalities. If, if several people for example, several fishery companies, use the same stock of fish, they certainly are cause they certainly influence each other and influence each other in negative way. And this is and this is what is, known, as you might have heard as the tragedy of the [UNKNOWN] When I use my car to drive across a city, I meet a rush hour, then of course

i create externalities because the presence of my car, contributes to traffic jams. You can continue these examples on and on. One common feature of externalities is, that if externalities remain uncontrolled, unregulated, uncoordinated, such externalities cause efficiency losses. Why is that the case? Think about that, if decisions are entirely private. If and at the same time. If consequences of these decisions, do not affect anyone but the decision maker, then these decisions are almost by default optimal, because the person who takes these decisions includes in his calculations, implicit or explicit, all of the gains and all of the costs, he is the only one, who benefits from the gains. He is the only one who accrues the course and therefore, he maximizes his, net results and and, as I said, as a result decisions are, optimal. Now, if at least a portion of the gains is felt not only by the decision maker, but by someone else. Or, if at least a portion of the course or maybe entire course are borne, not by the decision maker, but by someone else, then social, social optimality, social rationality become separated, divorced from the private, the [UNKNOWN] between what is good for the society, And what is good for an individual. Because individual, in her calculations, does not take in full account all of the costs, and all the benefits. Have a look at this picture, on the right-hand side of this slide. This is an example of an externality. Along the horizontal axis we measure we measure the scope of certain activity, I should say the scale, of a certain activity [SOUND] or simplicity sake, a [UNKNOWN] of production of a certain good. Along the vertical axis, let's measure costs, and benefits. The top curve shows the, the, the top curve shows the benefits. As a function of the of the volume. And, for simplicity sake let's assume these benefits are captured. Entirely by the decision maker, say by a, a producer that runs this business.

Now, let's talk about costs, as far as costs are concerned, [UNKNOWN] is different. Let's talk about the full cost of this activity, and full costs are shown by this curve, now what would be social optimal. Social optimum would be a level of activity where the, net benefits, or the difference, the vertical difference between benefits and full costs would be maximal. And at this point it's close to zero, so, apparently there is a little of this activity at this point it's also close to zero. Perhaps because there is too much of this activity beyond this point, it's negative. So everything beyond this point would be socially, counterproductive, would be socially wasteful. And if you're interested about optimal decision, this is the one where the benefits, minus the costs are at its highest level and this is the optimal decision. So, this is the optimal level. And these are, the net gains of this society in which decision is made. However, suppose that the producer bears only a portion of this total cost, and the rest of this total cost, is borne by someone else by the victims of externality. And then, if this externality is, left unregulated, the producer will not be concerned about a portion of this cost, about the difference between these two curves. Now, lets look about the cost. First of all, lets talk about the full course that are that are resulting from this activity. The curve, that describes how the full cost depend on this activity, is the top curve, and what is social optimal is the activity level where the, net gains which is the difference between the benefits and the cost. Is maximal, so, this is social optimal. Anything less than social optimal would be an, a level activity, activity level which is less than social optimal, would diminish the net social gains if it's a, above what is social optimal and then the efficiency gains would be smaller as well and beyond this point.

And that efficiency gains would would be negative and therefore, such activity would be completely wasteful to the society. So if [UNKNOWN] then the social interest the optimal decision, that would be right here. Suppose now, however, that a portion of the total cost is born by the producer, and this is the lower curve. And, a portion is borne, is, borne by someone else. And, this is, the difference between the total cost and the portion of the cost which is, borne by the producer. The balance this difference in cost, is borne by the victims of the externality, which is involved here. And as a result, the producer does not care, about this gap. Between these two curves, the only thing that it takes and take on directly, of course, provided that the externality is left. And regulated, is his own course. And that certainly effects in a very dramatic way, his calculations of course and benefits. Now, what is optimal for the producer is, is the activity level. The production level, which maximizes the difference between the, gross benefits and his own course. And this optimal production level is way higher, than what his social optimal. Therefore, from his personal point of view the producer behaves optimally. From the social point of view, he overproduces. And, although, as a result his personal profit. Considerably increases, in comparison to the social optimal. The social gains decrease, they become much more here the social means, where the decision, individual private decision by the producer is made. And you can see that, they're way smaller than what is optimal for the society in fact, one can easily imagine a situation in what is optimal. Or the producer is actually something that the entails negative, net gains, for the society. So that's, that's a clear example, clear illustration of an externality and, and,

and quite obviously, in the case of externality here you see a loss of efficiency. Private decision is not, social optimal so it might be worthwhile to ask. To what extent this difference, this gap, this separation, between what is individual irrational and social optimal to what extent it is typical, to what extent perhaps, it's just you know, a happy accident. And the answer is that, it's very common and very usual that a combination of social optima, if people interact with each other without, using markets, is not Pareto-efficient. And in fact, it's a very rare exception that a, combination of social optima, is Pareto efficient. And the best way to illustrate this simple point, and that's quite important to keep in mind, if you want to really appreciate the role of government in modern economies, is to use simple models, simple concept of what is an outcome, of individually made rational decisions, and this is that the concept of the Nash equilibrium. Suppose you have several individual, several decision makers. Each one makes a certain decisions and people are effecting each other, so that, my preference is my well being, my utility, depends on decisions taken by someone else. What is a Nash equilibrium? Everybody makes their own decision, and in a Nash equilibrium, my decision is, my best response to the decisions of others I cannot control, decisions of other agents. They are beyond my control, but I am aware of these decisions and I am trying to respond, as best as possible, to these decisions, and so does everyone else. So, in a Nash equilibrium, no one has an incentive, to deviate from her personal choice, given the choice of other individuals. So, this decisions are, individual optimal. Are they social optimal? Are they Pareto-optimal? Well, no they aren't. And they are, they are, not optimal by Pareto as much as on the possible, and let me

explain why. Have a look at this [SOUND] illustration. Suppose that we measure, the decision variable of the first individual along the vertical, horizontal axis, that is so to say x1. Suppose we measure, the decision of the second variable individual along the vertical variable. And this is, so to say, x2. And, each individual has utility function. Which depends both. On x1 and x2. Utility function of the first individual, depends on his own choice but it also depends on the choice of the other individual. And I will make my choice to maximize my utility but, am aware that my choice is also affected by the choice of another person and vice-versa. So, what is a Nash equilibria? Suppose that, the second individual has made up her mind and has chosen her has made her choice at this point, as a result what is available for me as. So to say a budget line, is this horizontal line and I maximize my preferences along this horizontal line, and my outcome of this maximization is this point, because at this point my difference curve, is tangent to the budget line. The same thing. Is true about the second individual, here he acts on my choice, if I am the first individual and my choice is x1. So, his area of choice is this vertical line, and this is his budget line, and on this budget line, he has to choose. The best possible outcome and, of course, in the best possible outcome, his indifference curve has to be tangent, to the budget line as well. So, this is the outcome. This is a, Nash equilibrium. Is it Pareto-efficient? No, no, because if a location is Pareto-efficient then, as you probably know, indifference curves have to be tangent to each other. Here, they are not tangent. They are perpendicular, and nothing can be further away from the tangent. And being perpendicular. So, there is no way that this could be Pareto-optimal.

And in fact, this location between these indifferent Coarse. As you can see, he is superior for both individuals. So, if there were a chance for those individuals to move from this point to this point. Both of them would have been better off as a result. Trouble is, this Pareto-superior allocation, cannot be supported by private decision-making. It requires some coordination, [SOUND] and individuals are, unable to achieve this coordination on their own. Well, it might not be as gloomy. Because what would be kind of natural expected reaction, to this, quite obvious, the market failure because private decisions fail to achieve in efficient outcome, would be okay. Lets invite government. Lets some agency that will coordinate these individuals. And will force them, to make decisions, that would take them away from the Nash equilibrium and will put them here, and as a result both of them will be better off. And they will be applauding, such an agency and will be grateful to it for being, for helping them to resolve this coordination problem. But there are might be private alternatives. So do not rush to invite government because you know, governments can can, can cause considerable damage to to to, to, to the economy as people of course, has suspect of government, often say, if there is a chance to achieve, a private resolution of this market failure, and according to Ronald Coase there is such possibility. Ronald Coase, of course, is a renowned American economist just recently, passed away in a very advanced age who made himself famous among other things by spelling out the so-called Coase theorem. The amazing thing, about the Coase theorem is that, this is perhaps the most popular concept of modern economics.

And not just economics, but a number of, adjacent social sciences. If you Google, Coase theorem, then you'll probably realize that it's, the, The most popular hash tag in old vocabulary of economist. And at the same time, the Coarse theorem is actually a very simple statement. It's almost trivial, and it says that rational [UNKNOWN] through negotiations, will always be able this is missed on the slide unfortunately. To make the best use of available resources. I need to reach Pareto-optimality. Coase Theorem places hope on negotiations. We've reached, a private solution. Lets get back to this picture. And realize, that this private solution is not, the best thing that we can do. Individually uni-lateral, we cannot improve this solution, it requires a collective action. By agreement, by collective action, both of us conclude that, the first agent in fact, has to make his choice not at this point, but at this point and the second agent has to reciprocate and make his choice not at this point, but at this point and as a result both of them will be better off. This is a private solution. This is a private solution because individuals reach this improvement upon themselves. No one forces them, no one helps them. It's because they're rational decision making, again. The Coarse theorem, perhaps it's powerful, and so influential because it extends the, idea of rationality from individuals to groups. To collectives. If not just individuals, but groups can be collective, if they can be reasonable, if they can be trustworthy. If they can communicate, negotiate and can stick to agreements that they have reached, then you don't need the government because individuals through these, private solutions can reach Pareto-optimality. Of course, it doesn't happen all the time. And sadly it doesn't happen most of the time. Why? Because there is one important qualification for the Coase Theorem, and this one is, that

transaction cost. In other words, the cost involved, to negotiate a agreement. To enforce this agreement. To make sure that no one, shorts from the obligation that this person has taken upon himself. That this, transaction costs are reasonable, they are not too high. In fact, often time, the cost of negotiating, finding agreement and implementing, enforcing this agreement could be very high, could be in fact prohibitively high and in this case, the Coase theorem, offers no remedy. And, indeed transaction costs could be, very high especially when the number of involved individuals is high. Imagine the situation when there are, simply two, three, maybe a handful of people that are involved in a potential market fail. They know each other, they trust each other. They can, they're, they can argue with each other. They talk to each other a little bit, and they come to an agreement in this case, yes. The Coase theorem reigns supreme. There is no need, to be involved in what happens among these people. However, it mentioned that there are that there is thousand or thousand of people, there are ten thousands of people, there are millions of people. They have, have to agree to act collectively and to reach an outcome which is provided for by the Coase theorem and it's quite obvious, this negotiation is very likely to fail. And as a result, transaction costs are very high, and private solutions are simply, impossible. Uh,lets talk a little bit later, about what are the failures of this collective action, especially, if the number of people is, large as is commonly the case in modern societies and modern [UNKNOWN]. [SOUND] [MUSIC]