Economics of Transition      Aug - Dec 2003        Economics 232  

Exercise #4

Externalities and the Nature of the Frim

(Due Wed, Oct 22nd, in class)

In this exercise you will practice modelling and analyzing the effects of externalities.  Consider an economy with 100 people.  Each 

person can produce one piece of fruit (by climbing a tree to get it) but consumes only the fruits produced by others, thus they must

trade.  The probability of making a trade with another person is P.  The expected value of producing a fruit is the value of the fruit,

call it y, (assume it's $1 for now) times the probability of making a trade, or P*y.  The cost of producing a fruit, c, differs among

people, and are distributed uniformly over the [0,1] interval.  People choose to produce a fruit if P*y > c.

Based on the above, answer the following: 

(a) Suppose P = 0.6.  What is the level of aggregate output, Y?  Note Y = (y * # agents with P*y>c).

(b) Suppose the relationship between aggregate output and the probability of making a trade is P(Y) = [Y-1]/Y.

Are there externalities in this economy?  What type?  Calculate all equilibria.

(c) Suppose the relationship between aggregate output and the probability of making a trade is P(Y) = 1/Y.

Are there externalities in this economy?  What type?  Give a real  world example when this type of externality might arise.

Read "The Nature of the Firm" by Ronald Coase (Economica, New Series, v. 4, n. 16, November 1937, pp. 386-405; it is 

available at www.jstor.org) and answer the following questions.

1. Are all transactions in the U.S. economy guided by supply, demand, and the equilibrium price?  For example, how are class times

and rooms set at Davidson College?
2. Why do firms exist?
3. How is economic activity organized within firms? 
4. How is economic activity organized between firms? 
5. Why isn't all production carried out in one big firm?  What are  the limits on a firm's size?
6. Pick a merger between two large companies in recent  years (for example, Time Warner & AOL) and discuss the pros and cons 

of the merger.  

7. What are some examples of transactions costs --  costs of using the market mechanism?

8. How would you relate this article to the reform of centrally planned economies?