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Cease argued that individuals could organize bargains so as to bring about an efficient outcome and eliminate externalities without without government intervention. The government should restrict its role to facilitating bargaining among the affected groups or individuals and to enforcing any contracts that result. This result, often known as the “Cease Theorem” requires that: property rights are well defined; the number of people involved is small; and arraigning costs are very small Only if all three conditions, apply then individual bargaining will solve the problem of externalities.
All that is needed is a common law or statutory rule, which assigns rights over the externalities to one party or another. The market/pricing mechanism will then function in the same way as it does for the ordinary goods and services over which rights clearly defined. Thus Case’s theorem has helped in the emergence of numerous policy formulations in the welfare imperatives of societies. 5. Explain Arrows Impossibility Theorem. NAS.
The democratic procedure for reaching a social choice or group session is the expression of their preferences by individuals through free voting. Social choice will be determined by the majority rule. But Arrow has demonstrated through his impossibility theorem that consistent social choices cannot be made without violating the consistency or transitivity condition. The social choice on the basis of majority rule may be inconsistent even if individual preferences are consistent.
Arrow first considers a simple case of two alternative social states and proves that in this case group decision or social choice through a majority rule yields a social choice, which can satisfy all the five conditions. But when there are more than two alternatives, majority rule fails to yield a social choice without violating at least one of the five conditions. Thus, Arrow’s theorem says that if the decision-making body has at least two members and at least three options to decide among, then it is impossible to design a social choice function that satisfies all these conditions at once.
Alternative Social States BIB 13 12 II z 3 Ranking of Alternatives by Individuals and Social Choices In this table three individuals A, B and C who constitutes the society have voted for three alternative social states X, Y and Z by writing 3, against he most preferred alternative, 2 for the next preferred alternative and 1 for the least preferred alternative. Majority rule leads to inconsistent social choices because on the one hand, X has been preferred to Z by the majority and on the other hand, Z has also been preferred to X by majority, which is contradictory or inconsistent.
Arrow has derived three consequences to explain his impossibility theorem. According to Consequence l, whenever the two individuals prefer X to Y, then irrespective of the rank of the third alternative Z, society will prefer X to Y. According to Consequence II, if in a given social choice, the will of individual reveals against the opposition of individual B, then the will of A will certainly prevail in case individual B is different or agrees with A. According to Consequence Ill, if individuals A and B have exactly conflicting interests in the choice between two alternatives X and Y, then the society will be indifferent between X and Y.
It is interesting to note that the simple proof of the impossibility theorem follows from Consequence Ill. For instance, if individual A prefers X to Y and individual B prefers Y to Z and if society opts for X, then A will be a dictator in as much as her choice will always be social choice. Thus, ArroWs theorem says that ‘if the decision-making body has at least two members and at least three options to decide among, then it is impossible to design a social choice function that satisfies all these conditions at once.
Arrow, therefore concludes that it is impossible to derive a social ordering of different conceivable alternative social states on the basis of the individual ordering of those social states without violating at least one of the value judgments expressed in the five conditions of social choices. This is in essence his impossibility theorem. Discuss the concept of asymmetric information. Explain the relation . Among moral hazard, adverse selection and signaling, giving suitable examples.
NAS. Asymmetric information signifies a situation in which one party involved in transaction with another, has more or superior knowledge and information than the other. This is often the case between buyer and seller, where seller has more knowledge than buyer. However, the opposite condition can also happen at times. The situation can potentially be harmful as the party with more information can take advantage of other’s lack of knowledge and thereby exploit the other party.
Asymmetric information is the source of two major problems such as the allowing: Moral Hazard – This reflects on the immoral behavior of a party with asymmetric information subsequent to a transaction. For example, some people commit arson purposely to reap benefits from the fire insurance. After being insured, a driver may drive recklessly as damage in the event of accident will be borne by the insurance company. Adverse Selection – In this case, the party displays immoral behavior by taking advantage of the knowledge or asymmetric information prior to transaction.
For example, some people secure life insurance aware of the languishing health. A bank may fail to observe the risk-return characteristics f a project. Consequently, it will extend credit facilities to bad projects while rationing credit to good projects. The presence of asymmetric information creates an adverse selection problem: if consumers cannot tell the quality of a product and are willing to pay only an average price for it, then this price is more attractive for sellers who have bad products than to seller who have good products (hence the term adverse selection).
Consequently, more bad products (I. E lemons) will be offered than good products. Now, if consumers are rational, they should anticipate this adverse selection and expect that at any given price, a Mandalay chosen product is more likely to be a lemon than a good product. Of course, these expectations imply a lower willingness to pay for products and so the proportion of goods products that is actually offered falls further. Eventually, this process may lead to a complete breakdown of the market.
Signaling – Initiative taken by individuals of informed category in markets characterized by adverse selection to help identify their true risk category. For example, In the lemons model if sellers of a good product could find some activity that was less costly for them than for seller of a bad reduce, then it might pay them to undertake this activity as a signal of good quality product. The buyers, too, would learn that the signal was associated with good quality product. 7.
Do you agree with the proposition that a risk-averse person will optimally buy full insurance if the insurance is actuarially fair? Give reasons in support of your answer. NAS. Yes a risk-averse person will optimally buy full insurance if the insurance is actually fair as the expected utility of such consumer rises with the purchase of insurance although expected wealth is unchanged. Since insurance increases the consumer’s welfare, she is willing to pay some costive price in excess of the actuarially fair premium to defray risk.