Imperfect information, legal institutions and externalities
Creators: name: Bennett, Nancy D.
Publisher: name: University of British Columbia
Year: 2010

description: Externalities have presented a difficulty in the attainment of Pareto optimal competitive equilibria in decentralized market economies. An externality can be said to exist whenever technological interdependencies between economic agents give rise to a divergence between social marginal cost and private marginal cost. The problem is that we have not thoroughly explored the question of why externalities persist. That is, why are externalities not internalized optimally in a market system? Why do markets fail? This thesis approaches these questions by examining the sources of market failure. One source of market failure, transaction costs, is the focus of the thesis. The assumption that transaction costs are zero is relaxed. One particular type of transaction cost, imperfect technological information, is examined to see if the inclusion of this transaction cost in an otherwise competitive model can explain the persistence of specific classes of externalities. The externalities considered are private external diseconomies, i.e., interdependencies between agents that affect individuals separately. I do not consider externalities that have public good attributes. We cannot fully discuss transaction costs without considering the effect of the institutions existing in an economy on these costs. This thesis examines the relationship between one institution, the legal system, and imperfect information. The legal system comprises the set of individual rights, common and statutory laws, court system, and legal services markets which exist in a decentralized economy. The thesis entails a theoretical examination of the persistence of private external diseconomies, given imperfect information. First, a taxonomy of legal rights is formulated. The importance of rights is established by showing that the assignment of rights influences resource allocation by affecting the equilibrium point attained given any type of externality (private or public) and zero transaction costs. A geometric bargaining model provides a counter-example to the "Coase theorem". But this model is too general to deal with specific externality and imperfect information cases. Imperfect information in the context of externalities is defined explicitly and models employed to show that under certain information/ externality cases, private markets either may not arise to allocate resources, or, if markets do exist, they may operate inefficiently. The markets examined are private insurance markets as they are one type of institution economic theory predicts would arise to internalize externalities in the case of imperfect information. It is found that insurance, as a market allocation mechanism, may not internalize certain types of externalities when information is imperfect. The legal system is then examined in greater detail as an example of a nonmarket allocation mechanism. In particular, formal models are used to investigate the effect of specific liability laws and due care standards on the attainment of Pareto optimal resource allocation, given private externalities and imperfect information. It is found that legal liability rules do not in general lead to optimal equilibria. In certain cases however, liability laws may improve social welfare by providing incentives for the parties involved in the externality to alter their behavior responsible for the externality. In contrasting private insurance markets and legal rules with respect to the information each requires to operate and the equilibria attainable (if they exist), it is found that legal rules may be superior to private insurance markets. This result occurs because legal rules require less precise information than do insurance markets and may also be able to affect the behavior of all parties involved in the externality. Insurance generally covers only the parties damaged by the externality. In summary, this thesis provides a theoretical rationale for one type of market failure due to externalities and points out a nonmarket method of improving social welfare when externalities exist.