Consider these three situations.
1. Builder Babu constructs a new apartment complex in Free Market Colony. Adjoining the entrance to the complex is an electricity pole (or a water line or a public tap), located on the road margin, which apart from adversely affecting the elevation of the new building also inconveniences vehicles entering the compound. Builder Babu applies to get the electricity pole shifted to the other side of the road, adjoining the backside of the neighbouring house, and makes the required payment for shifting. However, once the elctricity utility starts the shifting work, the Not-in-my-backyard (NIMBY) effect comes to the fore and local residents oppose the shifting. They couch their opposition on the grounds that shifting would result in drawing lines across the street, thereby spoiling its elevation (or cutting the road, though the road restoration costs are already paid to the municipality).
2. Welder Ram proposes to start a welding shop in a shop he has taken on lease in the narrow and congested Free Market Street. However, being a hazardous activity, the presence of a transformer at the road margin and adjacent to the entrance of his shop means that he cannot start his business activity without shifting it. He therefore approaches the electricity call center and pays the required shifting charges. The electricity utility's contractor starts the work only to face strong and vocal opposition from the shop owners in whose area it was proposed to relocate the transformer.
The congested nature of the locality means that there is no other land (actually it needs only a small space to erect the plinth and mount the transformer, but the transformer looming in front of their shops is a deterrrent) available on the road margin to locate the transformer. In other words, in the absence of any vacant land or space, the transformer has to always remain mounted adjacent to some shop.
3. Consider the flower market located in the narrow Flower Street. The flower market generates massive quantities of waste material which was being dumped in the only available vacant land in the vicinity (and then lifted by the municipal authorities everyday evening). Now the owner of the land has returned from the abroad and decided to construct a shopping complex in his land. Having lost their temporary waste disposal location, the flower market association decide to request the municipal authorities for a dumper bin for Flower Street. Municipal authorities readily oblige and transport the bin to Flower Street.
Now the problem starts. In the absence of any vacant land, the dumper bin has to be located on the road margin over the covered drain and footpath. The congested and closely spaced nature of the shops in the street means that it is inevitable that the bin be located adjacent to atleast one shop. None of the flower shop owners are willing to sacrifice the entrance to their shop with the sight of a dumper bin.
All the aforementioned examples are commonplace in our cities and source of considerable acrimony between people and causes neighbourhood disputes. They are also some of the commonest types of complaints received by municipal authorities and utility officials in many Indian cities. However, the involvement of government rarely solves the problem. If anything, it often ends up exacerbating the problem as the officials accept bribes and take sides in a neighbourhood dispute, where no side is right or wrong.
Ideally such disputes ought to be settled through civic organizations like Residents Welfare Associations (RWAs) or other local commercial associations. The local social capital is the most effective instrument to solve such problems. However, if the local community fails to arrive at an amicable solution, the free market has a possible solution.
Econ 101 would see all three as classic test cases for application of the Kaldor-Hicks criterion. Under the Kaldor test, an outcome will be efficient if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are prepared to accept. The Hicks test stipulates an outcome to be efficient if the maximum amount the losers are prepared to offer the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forego the change. The Hicks test is from the loser side and the Kaldor test the gainer side reasoning.
The aforementioned commonplace civic disputes can be subjected to Kaldor-Hicks bargains. In fact, there may be nothing immoral about such negotiations, especially when the alternatives leave everyone worse off. Such informal and mutually negotiated dispute settlement mechanisms were employed even in olden times, mediated by local councils of elders in many societies. Even today, atleast in some commercial areas, such disputes would get settled before the local rowdy who would, apart from intermediating to identify a mutually acceptable price, also wring out his share from both parties.
The danger lies in the institutionalization of such informal arrangements, where in the absence of appropiate legal instruments, non-state actors occupy the vacuum and damage the fabric of the local society. However, instead of undesirable lumpen elements, the local community associations can embrace this approach and provide the platform for such bargaining.
Showing posts sorted by date for query Kaldor HIcks. Sort by relevance Show all posts
Showing posts sorted by date for query Kaldor HIcks. Sort by relevance Show all posts
Monday, February 8, 2010
Monday, April 28, 2008
Coasean bargains on civic issues
There is an interesting blog debate going on between Megan McArdle and Kathy G on the application of Coase Theorem.
The debate was triggered off by Megan McArdle's suggestion that Coasean bargain would take care of any conflict of preferences between two neighbours on enjoying loud music and silence. Kathy G reponded that a Coasean bargain is not possible in such a situation, since both transactions costs (information costs on locating the relevant rules, enforcement costs in getting police to register cases) are high and property rights ill-defined (Rules on loud music, silence etc).
The Coase Theorem states that, in a dispute concerning an externality, if transaction costs are low (or nonexistent) and property rights are well-defined, the parties can bargain their way to an Pareto efficient outcome(with no one being worse off and at least one person being better off). The Coase Theorem is value neutral, in so far as it is silent on fairness.
Kathy G illustrates this with an example, "A poor person living near a toxic waste dump may have a very strong preference indeed to see that waste dump removed. But even if transaction costs are zero and property rights are well-defined, that doesn't mean she'll prevail in a Coase bargaining scenario. If she has less money than the polluter, her preference, no matter how strong, will not be realized. All the Coase theorem says is that, after bargaining, she won't end up worse off. But if her resources are less than her opponent's, her preferences would not be satisfied."
Kathy G writes, "Libertarians tend to be fond of the Coase theorem, but that is because they often misunderstand it. They're likely to be enamored of the idea of autonomous actors in a free market bargaining their way to an efficient solution, with government staying out of the matter entirely. They especially prefer the Coase solution to the Pigouvian mechanism, in which the externality is internalized via a tax. But in the real world, a Coase solution to an externality is not necessarily going to be any more efficient than a Pigouvian one."
Though it is widely accepted that a Coasean bargain is difficult in the real world, Coasean-style transaction costs can be used as an analytical tool to understand how, and under what conditions, markets work.
I had dwelt with the possibility of Coasean bargains in urban areas in an earlier post in the context of Kaldor-Hicks test to determine whether an outcome is efficient or not.
The problem, as Kathy G points out, lies in the transaction costs and definition of property rights that are necessary to strike the locally negotiated bargain. This is why libertarian solutions to neighbourhood civic problems fail, thereby necessitating intrusive Government regulation. But such regulations invariably develop a web of bureaucracy, with its attendant corruption and other distortions, that detracts from achieving its objectives. In the circumstances, the right way forward would appear to be taking adequate steps to lower transaction costs (local dispute settlement/negotiating mechanisms) and more clearly define individual and common property rights.
Update 1 (2/8/2010)
NYT reports of a windfarm in Oregon paying $5000 to buy silence of neighbors on the sounds made by wind turbines.
The debate was triggered off by Megan McArdle's suggestion that Coasean bargain would take care of any conflict of preferences between two neighbours on enjoying loud music and silence. Kathy G reponded that a Coasean bargain is not possible in such a situation, since both transactions costs (information costs on locating the relevant rules, enforcement costs in getting police to register cases) are high and property rights ill-defined (Rules on loud music, silence etc).
The Coase Theorem states that, in a dispute concerning an externality, if transaction costs are low (or nonexistent) and property rights are well-defined, the parties can bargain their way to an Pareto efficient outcome(with no one being worse off and at least one person being better off). The Coase Theorem is value neutral, in so far as it is silent on fairness.
Kathy G illustrates this with an example, "A poor person living near a toxic waste dump may have a very strong preference indeed to see that waste dump removed. But even if transaction costs are zero and property rights are well-defined, that doesn't mean she'll prevail in a Coase bargaining scenario. If she has less money than the polluter, her preference, no matter how strong, will not be realized. All the Coase theorem says is that, after bargaining, she won't end up worse off. But if her resources are less than her opponent's, her preferences would not be satisfied."
Kathy G writes, "Libertarians tend to be fond of the Coase theorem, but that is because they often misunderstand it. They're likely to be enamored of the idea of autonomous actors in a free market bargaining their way to an efficient solution, with government staying out of the matter entirely. They especially prefer the Coase solution to the Pigouvian mechanism, in which the externality is internalized via a tax. But in the real world, a Coase solution to an externality is not necessarily going to be any more efficient than a Pigouvian one."
Though it is widely accepted that a Coasean bargain is difficult in the real world, Coasean-style transaction costs can be used as an analytical tool to understand how, and under what conditions, markets work.
I had dwelt with the possibility of Coasean bargains in urban areas in an earlier post in the context of Kaldor-Hicks test to determine whether an outcome is efficient or not.
It is commonplace to have complaints against some objectionable shop or commercial establishment located in predominantly residential areas, causing inconvenience to its neighbours. There is a simple solution to this problem. Assume Mr Welder wants to set up a welding shop in Soundfree Colony. Assume also that the Plant generates costs on the neighbours amounting to Rs A, and it would cost Mr Welder Rs B to relocate elsewhere. If Rs B > Rs A, then there is a possibility for a mutually beneficial bargain between the parties and Mr Welder continuing his business in Sound free colony. (The cost could for example be the amount required for setting up sound proofing system)
The problem, as Kathy G points out, lies in the transaction costs and definition of property rights that are necessary to strike the locally negotiated bargain. This is why libertarian solutions to neighbourhood civic problems fail, thereby necessitating intrusive Government regulation. But such regulations invariably develop a web of bureaucracy, with its attendant corruption and other distortions, that detracts from achieving its objectives. In the circumstances, the right way forward would appear to be taking adequate steps to lower transaction costs (local dispute settlement/negotiating mechanisms) and more clearly define individual and common property rights.
Update 1 (2/8/2010)
NYT reports of a windfarm in Oregon paying $5000 to buy silence of neighbors on the sounds made by wind turbines.
Friday, July 13, 2007
Kaldor-Hicks Test for Economic Efficiency
When faced with decision making, we rarely ever weigh economic efficiency concerns. This disregard for economic efficiency ultimately causes distorted and undesirable outcomes. Economic efficiency results when the costs incurred in the emergence of a final outcome (a good, a service, or an event) is the lowest. There are many measures for this economic efficiency, of which two are important for us - Pareto efficiency and Kaldor-Hicks criterion. It is appropriate if all the possible outcomes or options are tested against these tests, before we finalize our preferences.
An outcome is said to be Pareto optimal, if we cannot make one person better off without making another person worse off. This criterion for efficiency is thought to impose a very strict standard, since there are very few transactions in the real world which will stand this test. Most exchanges or transactions involve external costs, which on most ocassions imposes substantial costs on the society and its inhabitants.
The Kaldor-Hicks criterion, formulated by Nicholas Kaldor and John Hicks, imposes less stringent conditions and can be applied to many practical situations. The Kaldor-Hicks criterion is itself a mixture of the separate Kaldor and Hicks tests. Under the Kaldor test, an outcome will be efficient if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are prepared to accept. The Hicks test stipulates an outcome to be efficient if the maximum amount the losers are prepared to offer the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forego the change. The Hicks test is from the loser side and the Kaldor test the gainer side reasoning.
The combined test stipulates that an outcome is more efficient if those made better off could in theory compensate those made worse off, thereby resulting in a Pareto optimal outcome or atleast a Pareto improvement. It needs to be emphasised that, unlike a Pareto optimal solution, a Kaldor-Hicks efficient outcome can leave some people worse off. In so far as most exchanges end up making some people better off while making atleast a few people worse off, Kaldor-Hicks tests ask what would happen if the winners were to compensate the losers.
Further, while the Pareto efficiency requires that no party is actually made worse off, the Kaldor-Hicks efficiency only requires the possibility of compensation to exist. It is the discretion of the participants to execute the mutually beneficial transaction. We can conclude that any economically efficient decision should ideally conform to the Pareto efficiency test, or atleast to the Kaldor-Hicks test.
We need to be certain that the alternative chosen from a bouquet of options shoud be the most ideal and efficient solution to the particular problem. The Kaldor-Hicks criterion can be widely applied to policy and decision making situations. It can be the basis for cost-benefit analysis on investment decisions, redistribution policies (like subsidies), taxation policies and many other decisions.
Consider, Mr Polluter who wants to set up Pollution Factory at Nature Village. He has chosen Nature Village, because it confers on him certain advantages, as compared to other locations (Maybe, Nature Village has cheap land, or a rivulet stream which provides adequate water round the year). We are concerned about the costs imposed by Mr Polluter's factory on Nature Village, and how much the residents of the village have to be paid to persuade them to accept setting up the Plant there. Assume, Pollution Factory inflicts net external costs amounting to about Rs X, which is also the minimum amount demanded by the villagers to put in place the mechanisms to remedy the costs inflicted by the factory. Also assume, it would cost Mr Polluter and additional Rs Y to establish the Plant at the next best location. If Rs Y > Rs X, then there is the poossibility of a mutually beneficial bargain between the two parties.
Similar examples galore in urban areas. It is commonplace to have complaints against some objectionable shop or commercial establishment located in predominantly residential areas, causing inconvenience to its neighbours. (The Corporation typically gets 5-10 such complaints every day) There is a simple solution to this problem. Assume Mr Welder wants to set up a welding shop in Soundfree Colony. Assume also that the Plant generates costs on the neighbours amounting to Rs A, and it would cost Mr Welder Rs B to relocate elsewhere. If Rs B > Rs A, then there is a possibility for a mutually beneficial bargain between the parties and Mr Welder continuing his business in Sound free colony. (The cost could for example be the amount required for setting up sound proofing system)
I believe that instead of blanket regulation by the Government, we should encourage similar market negotiation between the parties so as to solve such problems. But this would require putting in place formal and informal mechanisms like Residents' Welfare Associations (RWAs), which can facilitate such negotiations and its enforcement.
An outcome is said to be Pareto optimal, if we cannot make one person better off without making another person worse off. This criterion for efficiency is thought to impose a very strict standard, since there are very few transactions in the real world which will stand this test. Most exchanges or transactions involve external costs, which on most ocassions imposes substantial costs on the society and its inhabitants.
The Kaldor-Hicks criterion, formulated by Nicholas Kaldor and John Hicks, imposes less stringent conditions and can be applied to many practical situations. The Kaldor-Hicks criterion is itself a mixture of the separate Kaldor and Hicks tests. Under the Kaldor test, an outcome will be efficient if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are prepared to accept. The Hicks test stipulates an outcome to be efficient if the maximum amount the losers are prepared to offer the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forego the change. The Hicks test is from the loser side and the Kaldor test the gainer side reasoning.
The combined test stipulates that an outcome is more efficient if those made better off could in theory compensate those made worse off, thereby resulting in a Pareto optimal outcome or atleast a Pareto improvement. It needs to be emphasised that, unlike a Pareto optimal solution, a Kaldor-Hicks efficient outcome can leave some people worse off. In so far as most exchanges end up making some people better off while making atleast a few people worse off, Kaldor-Hicks tests ask what would happen if the winners were to compensate the losers.
Further, while the Pareto efficiency requires that no party is actually made worse off, the Kaldor-Hicks efficiency only requires the possibility of compensation to exist. It is the discretion of the participants to execute the mutually beneficial transaction. We can conclude that any economically efficient decision should ideally conform to the Pareto efficiency test, or atleast to the Kaldor-Hicks test.
We need to be certain that the alternative chosen from a bouquet of options shoud be the most ideal and efficient solution to the particular problem. The Kaldor-Hicks criterion can be widely applied to policy and decision making situations. It can be the basis for cost-benefit analysis on investment decisions, redistribution policies (like subsidies), taxation policies and many other decisions.
Consider, Mr Polluter who wants to set up Pollution Factory at Nature Village. He has chosen Nature Village, because it confers on him certain advantages, as compared to other locations (Maybe, Nature Village has cheap land, or a rivulet stream which provides adequate water round the year). We are concerned about the costs imposed by Mr Polluter's factory on Nature Village, and how much the residents of the village have to be paid to persuade them to accept setting up the Plant there. Assume, Pollution Factory inflicts net external costs amounting to about Rs X, which is also the minimum amount demanded by the villagers to put in place the mechanisms to remedy the costs inflicted by the factory. Also assume, it would cost Mr Polluter and additional Rs Y to establish the Plant at the next best location. If Rs Y > Rs X, then there is the poossibility of a mutually beneficial bargain between the two parties.
Similar examples galore in urban areas. It is commonplace to have complaints against some objectionable shop or commercial establishment located in predominantly residential areas, causing inconvenience to its neighbours. (The Corporation typically gets 5-10 such complaints every day) There is a simple solution to this problem. Assume Mr Welder wants to set up a welding shop in Soundfree Colony. Assume also that the Plant generates costs on the neighbours amounting to Rs A, and it would cost Mr Welder Rs B to relocate elsewhere. If Rs B > Rs A, then there is a possibility for a mutually beneficial bargain between the parties and Mr Welder continuing his business in Sound free colony. (The cost could for example be the amount required for setting up sound proofing system)
I believe that instead of blanket regulation by the Government, we should encourage similar market negotiation between the parties so as to solve such problems. But this would require putting in place formal and informal mechanisms like Residents' Welfare Associations (RWAs), which can facilitate such negotiations and its enforcement.
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