Question

“If there are no transaction costs, then an efficient outcome can be achieved in the presence of an externality if the government completely allocates tradable property rights over the externality generating activity. Furthermore, the final outcome will be invariant to the specific initial allocation of property rights that is chosen by the government.” Is this claim true, false or ambiguous? Justify your answer. (Please write as much as you can)

Answer 1

Ans. This claim is true. In a market with no transaction cost and defined property rights, the market will come to the socially optimum equilibrium. This theorem is called Coase theorem. According to this theorm the person with the property rights will can negotiate with the other to get money in return for the other person using this property. For example, suppose there is a factory polluting a river which has a negative externality on the fishermen of the adjacent village. If the government allocates the property rights of the river to the fishermen then the fishermen and the factory can negotiate the amount of money to be paid to the fishermen to still use river for dping waste. This way the socially optimum equilibrium will be achieved. Similarly if the property rights of ther river were with the factory, so, the fisherment will pay the factory to reduce the level of pollution to the socially optimal level.

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