Econ 201c, UCLA Simon Board

1. Introduction 1

April 1, 2020

The welfare theorems state that:

(1) Competitive equilibrium is efficient

(2) Every efficient allocation is a competitive equilibrium.

In intermediate micro, you are told that we need three assumptions:

(1) No externalities

(2) No market power

(3) No private information

In this course, we will study the relationship between these three ideas, showing that they are
different sides of the same coin. In this introduction we’ll consider the classical externality problem
and the monopoly problem. This should be somewhat familar from intermediate mirco, but more
details can be found in MWG (ch. 11, 12).

1 Externalities

1.1 Externalities with Two Agents (MWG, 11.B)

Game

• Agent 1 chooses the level of pollution x ≥ 0 to maximize u1 (x). Assume u1 (x) is concave with
maximum x∗1 .

• Agent 2 gets utility u2 (x). Assume u2 (x) is decreasing and convex.2

The problem

• Assume utility is quasilinear, and agent i ultimately cares about ui (x) + T , where T is money.

• A welfare maximizing planner maximizes u1 (x) + u2 (x). Let this be xE , where “E” stands for
“efficient”

Solution 1: Taxation

• Suppose we set a tax τ = −u02 (xE ), so agent 1 incorporates her externality on agent 2.
1
Thanks to Diego Zúñiga and Roy Song for comments.
2
There can also be a positive externality (e.g., a knowledge spillover). The analysis is symmetric.

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• Agent 1 maximizes
max u1 (x) − τ x
x

which yields the FOC

u01 (x) + u02 (xE ) = 0

which means agent 1 chooses x = xE .

• There is a missing market for pollution; taxation put a price on the good and delivers efficiency.

Solution 2: A quota

• Suppose we set a quota on the pollution of x = xE .

• Agent 1 solves
max u1 (x) s.t. x ≤ xE
x

which means agent 1 chooses x = xE .

Solution 3: Bargaining

• Suppose agent 2 makes agent 1 a take-it-or-leave-it (TIOLI) to not pollute.

• A contract (x, t) is a transfer t and a pollution level x. Agent 2 chooses the contract to
maximize his utility subject to agent 1 accepting,

max u2 (x) − t
x,t

s.t. u1 (x) + t ≥ u1 (x∗1 )

• Agent 2 will choose t to that the participation constraint of agent 1 binds. Thus, we have

max u2 (x) + u1 (x) − u1 (x∗1 )

x

• Hence agent 2 will offer a contract with x = xE .

• This is called the Coase Theorem. With quasilinear utility, the property right should not
affect the level of pollution, but only the direction of the transfer.

However, all these solutions require symmetric information

• The tax requires knowledge of u2

• The quota requires knowledge of xE , and hence u1 and u2 .

• Bargaining requires knowledge of u1 if agent 2 makes the offer, and u2 if agent 1 makes the
offer.

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1.2 Public Goods (MWG, 11.C)

Suppose n agents contribute to a public good, e.g. a new swimming pool. Game:
P
• Each agent simultaneously chooses xi . Let x = j xj .

• Agent i’s utility is ui (x) − cxi , where ui (·) is increasing and concave.

The first-best

• The efficient outcome equates marginal benefits and costs

X
u0i (xE ) = c (1)
i

Note that it does not matter who pays the cost.

The equilibrium if each agent makes voluntary contributions

• Agent i takes other’s contributions as given and solves

X
max ui (xi + xj ) − cxi
xi
j6=i

• Agent i’s optimal choice solves

u0i (x∗ ) = c if xi > 0 (2)

• But how can (2) hold for every agent at once?

• Suppose we can rank agents so that u01 (x) > . . . > u0n (x). Then only agent 1 will contribute:

c = u1 (x∗ ) > max u0i (x∗ )

i6=1

• So long as u0i (x) > 0 this is inefficient. One case see this from (1). This is called the “free-rider
problem”

Solution 1: Subsidize the public good.

• This is analogous to taxes, above. Suppose we subsidize agent 1 by

X
s= u0i (xE )
i6=1

• Agent 1 will choose x1 to maximize

 
X
u1 (x1 ) +  u0i (xE ) x1 − cx1
i6=1

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which coincides with first-best.

Solution 2: Introduce individualized prices to allow the group members to share the cost of the
public good.

• Suppose a firm comes in and does the following:

– They ask each agent how much of the public good they would like, xi , at price pi .

– The firm then builds x = min{xi }. Thus, if i doesn’t contribute then no-one gets a
swimming pool. This makes everyone pivotal.3

– The firm adds up the invididual contributions and uses them to pay the construction
cost, c.

• We claim that there exist prices such that (i) the agents all choose the efficient level of the
public good, and (ii) the firm breaks even. The key is to set the prices equal to the marginal
utilities at the first-best, pi = u0i (xE ).

• First, we claim that there is an equilibrium in which everyone chooses xi = xE .4 To see this
suppose that everyone else chooses xE , and ask what agent i would choose. She maximizes

ui (xi ) − pi x = ui (xi ) − u0i (xE ) x

 

The FOC of this is xi = xE .

• Second, we show the firm breaks even. The firm’s profits equal
! !
X X
E 0 E
Π= pi − c x = ui (x ) − c xE = 0
i i

where the first equality uses the definition of pi , and the last line uses equation (1). Thus the
sum of contributions equals the costs.

• This tells us that there is a way to split the cost of the pool so that we all benefit. Moreover,
if firms can freely enter, the free market can solve the public goods problem.5

However, both these solutions require symmetric information

• For example, the individualized prices assumes that firms know agents’ preferences and can
third-degree price discriminate.
3 P
In contrast, with voluntary contributions {xi }, if i doesn’t contribute then we still build a pool of size j6=i xj .
Note that if you can exclude people from the pool, then there are other ways to implement the first best.
4
There are other equilibria. For example, qi = 0 for all i. Hence this mechanism “partially implements” the
first-best rather than “fully implementing” it.
5
This is related to “Lindahl equilibrium”.

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• Later in the class, we’ll use mechanism design to study what the planner can do if they do
not know the preferences of the agent.

Notice that bargaining between agents is unlikely to work in this setting

• Suppose agents {2, . . . , n} wish to persuade agent 1 to contribute even more.

• Which of them should pay her to do so? We have exactly the same free-rider problem that
led to under provision in the first place.

• We need to have them jointly commit, as with the “individualized pricing”.

2 Market Power (MWG 12.B)

Model

• A firm faces decreasing demand curve p(q)

• There are constant marginal costs c

Monopoly pricing

• The firm’s profits are

Π = p(q)q − cq

• The FOC is
p(q) + p0 (q)q = c
| {z }
m(q)

where m(q) is marginal revenue. Intuitively, if we sell one more unit we get the revenue from
the marginal agent, but lose revenue from the inframarginal agents.

• The monopoly profit is then the area of the square

Π = (p(q ∗ ) − c)q ∗

or the area under the marginal revenue curve

Z q∗
Π= (m(q) − c)dq
0

• A monopolist provides too little quantity. How can can we solve this problem?

Solution 1: Subsidize the firm to produce more

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• When the firm sells a unit of the good, agents get consumer surplus. We should subsidize
quantity, to the firm internalizes this externality on consumers.

• In particular, let q E be the efficient quantity such that p(q E ) = c. The set the subsidy equal
to s = −p0 (q E )q E . This is a positive number since demand is downward sloping. The firm
maximizes
Π = p(q)q − cq + sq

which gives rise to the FOC

dΠ
= p(q) + p0 (q)q − c − p0 (q E )q E
dq

At q = q E , we thus have dΠ/dq = 0.

• This views the monopoly problem as an externality problem.

• Problem: this costs a lot of money, and requires the government know the demand curve. The
firm has an incentive to pretend its demand is larger than it is, so it gets a larger subsidy.

Solution 2: Buy out the firm

• The government can pay the monopolist Π∗ and take over the firm. It can then charge p = c.

• But how does the government know how much to pay the firm? Need to know demand and
cost.

Solution 3: Let the firm price discriminate

• Suppose the demand curve is made up of many consumers, each of whom want one unit.

• Suppose the firm knows each consumers willingness to pay.

• First degree price discrimination: The firm can charge each person their willingness to pay.

• The firm then captures all consumer surplus, and sells to an agent iff their value exceeds the
cost, c.

• This views the monopoly problem as an information problem

• Of course, the firm needs to know the valuation of every individual, and high value agents
have an incentive to lie and pretend to be low value agents.

Later in the class we’ll see how mechanism design can be used to solve the government’s problem
when the government does not know the cost of the firm, and does not want to give away too much
money.