[SOUND] >> Let's get back to discussing the implications of the breakdown of coordination that, in theory, is made possible

by the Coase Theorem. In particular, let's discuss what happens when this breakdown occurs, when the number of participating individuals is large. Essentially, we are talking about what is known as the collective action problem. These kind of problems were extensively discussed, researched and, in fact, brought up in economics by Mancur Olson, a well-known American economist and political scientist, also argued that collective action is hampered by the participation problem. The essence of collective action is that a number of individuals have to work together for a common cause. And each and every individual's contribution makes, as a rule, this individual better off. But not as much so that it would justify his participation because this individual would be made better off also by actions of other people. And, therefore, there is a disincentive to participate in collective action, at least to participate in a collective action at a socially optimal level. Again think about cost and benefits of participation, and it would be best to illustrate this by considering a public good provision problem. I assume that you know what is public good, but to those, for those who might have not heard about that, and even for those who did. Let me repeat that, a public good is a certain type of good that meets essentially two characteristics, two requirements. The first one, this good is available for public consumption, in that access to this good cannot be restricted. It's the so called non-exclusion property. So a public good is a good that meets two requirements. The first requirement is known as the joint consumability and the second one as the non-excludability. Joint consumability means that several

individuals can consume this public good without actually preventing others from doing the same. So, this good is available for consumption in full amount, irrespective of how many people consume it at the same time. And so this is joint consumability. Non-excludability means that people cannot be excluded from accessing this public good. Otherwise, it was be something, which is known as a club good. [COUGH] So let's see, what happens if this public good is funded by private decisions. Think about that. And consider a model of a public good, which is, presented on this slide here as a utility function of an individual which depends on his private consumption, x, [COUGH] and the amount of public good, g. And suppose that this is an additive utility function, and alpha of g is the component of utility, which is generated by the public good. And they would normally expect that alpha g would be a, an increasing function with decreasing marginal returns. So we have here a graph of the marginal utility of the public good and it is diminishing as it is shown in this picture. But let's get back to this model for a second. Suppose that I am to make a contribution to this public goods provision and to do so I have to sacrifice one unit of my private consumption. I will certainly gain from, increasing public good by one unit. And my gains will be equal precisely alpha prime of g. Now this is only a portion of the social benefits of my increased contribution simply because the same gain, alpha prime of g, are earned by all other agents, and supported in such agents. And as a result [COUGH] the the cross-social benefits of increased contribution of a public good is n times a prime of g. And my private benefits are alpha prime of g. So, as you see, I include in my private

calculations only a very small fraction of the total social benefits. And, as a result, my incentive to contribute to this provision of the public good is very weak. It is much weaker than what it, than eh, what it should be if I were driven by social interests. But I'm not. And as a result, if, a public good is funded by private decisions then we have an uncoordinated equilibrium. Where the social benefits the private benefits, of course, alpha prime of g, are equal exactly to the private cost, which is unity. Whereas social option requires that n times alpha prime of g should be put to unity and feel the difference. And this graph actually gives you a very clear vision and appreciation of this difference. At the socially optimal level, alpha prime of g should be equal to 1 over n. And if there is no coordination in the provision of public goods, then alpha prime of g equals 1. And as you see, a socially optimal level of public goods provision is way, way higher than it would have been if public goods were funded privately. And this is precisely what Mancur Olson had in mind where he was arguing about the complications of collective action in public good provision. He was concerned that individuals will have weakened incentives to participate in collective action. And at the extreme, they might be even free riding in that they will be refusing from contributing from participating. On the expectation that the public good will be funded by someone else. And I will because of the, lack of restrictions in, access to the public good, I have access to almost full benefits of this public good, irrespective of whether I participate or not. So if there is no coordination. If there is no external force external

agency that will, yes that will coerce individuals to make contributions to a public good at a socially optimal level, then a society will not have efficient infrastructure. It will not have a sufficiently a reliable police force. It will not have schools. It will not have hospitals. It will not have courts. It will not have many other public goods. It will not have reliable armed forces. And you obviously observed that most of the services on this list are provided by governments. These are public goods, and indeed in modern societies the provision of public goods is government responsibility. Why is it a government responsibility? Because governments can achieve the provisional public goods at the levels which are much closer to social optimal to social optimal levels than market equilibrium would. Now, if we have an agency. We have agreed that we need an agency government that assumes responsibility to coordinate individual decisions in the interest of society. Then this agency should have the required powers. And quite sadly these are powers to restrict individual freedoms. To restrict or, and or guide individual choices in the direction that people would not necessarily consider as optimal on their own. So the purpose of government the function of government, is to suppress, narrowly understood Individual rationality for the sake of aggregate welfare. Some decisions are pressed on people, some decisions are coerced. And we would normally expect that the result of this coercion people are worse off. Why not? Our freedom is restricted. We have to make choices to take actions, which we would not like to do on our own. And low and behold in fact we are better off with the government than without the government. Let's see how that can be illustrated in a very simple example that we just

considered. Let's take a special case of the public good provision problem. Let's remember the utility function was u of x, g, equals to x plus alpha of g. So lets take a specific form of alpha of g. Let's take alpha of g equals 2, square root of g. Suppose, again this is a pure illustration, of course, that we have ten agents. Ten is not such a huge number, but it's large enough to illustrate market failures in public good provision and the benefits of implementing socially optimal decisions. Suppose that eh, each of these agents has private wealth equal to 20. And they would use resources from this endowment of private wealth to fund a public good. So as we observed before, private equilibrium where decisions are made based on individual rationality would have the form, alpha prime of g equals 1. And in our case that means alpha prime of g, which is, of course, 1 over square root of g equals 1. Which basically means that the equilibrium level of public good will be just a unity. So what will be the welfare of this individuals? see, if g equals 1, then the gains of having access, individual gains to this public good, would be 2 times square root of g, which is 2. So it's 20, the endowment, plus 2, public goods gain, minus an individual's share in funding the public good. And let's assume that this amount is divided equally among individuals. So we have one unit of public good and eh, every individual pays 1 10th of that amount so the total gains of an individual would be 21.9. All right, now let's get back to the public optimum, which is n alpha prime of g, not just alpha prime of g. And that gives us and that gives us 10 over square root of g equals 1. And we see that the social optimal level of public good is not one but is 100, hundred times more. And if the social optimal level of public

good is indeed implemented, what would be the gains of agents? Let's have a look. The, the endowment 20 plus what agents would gain from the access to the public good, which is 2 square root of g. Square root of g is 10, which is 20. Well, of course it has to be funded. And it has to be funded quite extensively. A 100 units is equally divided among the agents, and how this money is collected, it's taxes, of course. Each agent is required to pay a flat, a, a lump sum tax equal 10. And as a result, the government will collect funds necessary to fund this public good, which is hundred. So, as a result, the individual welfare, at present, is 20. The endowment, minus tax 10, plus the gains of public good, and it's 30. And it's almost 50% as high as it would be if there is no government, if there is no taxation. If there is no if, if individuals are not coerced to make contributions to provide to the provisional public good above and beyond what they would cont, would have contributed otherwise. now, how this coercion comes about in, modern life. How states emerge, if you will. There are, different theories, different concepts, different models of states appearance in modern societies. And, the liberal one, the prevailing one, is the one of a social contract. >> Whereby, people voluntarily agree to submit themselves under the control of a public authority, of a public agency. And they are willing to surrender at least some of their freedoms, and to accept the right of this agency to tax, to enforce, to coerce and, as I said, to restrict freedoms. But they expect that, as a result, they will be better off. Because this public agency's role and function will be to prevent market failures, to coordinate individual decisions, and to move them away from inefficient

Nash equilibria to Pareto-optimal such as, in this picture. Government would force people to make choices that would put them in this position. And that requires indeed some coercion because free choices will put the society here, but the government decide will be here. And the society we will better off as a result. Of course, it's understood that operation of the government entails some costs. But if these costs are reasonable and that would be the case when governments are sufficiently accountable to the society. But the government people will be far better off than without the government. And this numerical example clearly illustrates the gains that would be available otherwise. Of course, not everyone subscribes to this, benevolent, idyllic, idyllic view of, of a, for government for state which is an outcome of social contract. You can find some wake formulations, which can be interpreted as social contract covenant even as for back as in the Bible. The concept of social contract was spelled out by liberal thinkers such as Jean-Jacques Rousseau. But there are alternative views of how states emerge and a much more cynical one was introduced and spelled out by the already mentioned Mancur Olson. That's the view of a stationary bandit, which is essentially a metaphor for an autocrat that establishes his control over certain jurisdiction and uses his powers for personal enrichment. And sadly quite a number of states in the modern world are much closer to the stationary bandit metaphor to, than to the social contract one. But history and desperations not withstanding in modern market democracies governments and states are expected to be literally and metaphorically, public servants. They provide services to the society. And on the surface, they provide education, they provide healthcare. They provide police services, police protection. They provide courts, infrastructure, so on and so forth.

But fundamentally, the main service of the government is to coordinate an economy and to prevent market failures that would occur if an economy is left uncoordinated. There is one thing I would like to discuss with you before we [COUGH] before we move to another point. And this is about the relations between a society and the government that is established around this society. Economists used to talk about this so-called principal-agent, setting or principal-agent relations. Such relations occur any time when one person or one entity engages another person, another entity, to perform certain services. If I'm a boss and if I hire an employee I'm the principal and the employee will be my agent, because he will be working in my interest, on my behalf, and under my control. If I, I'm a private individual and I'm involved in a court case I would hire a lawyer and this lawyer will be my agent. His job will be to present my case in court. If I am a share holder, then I need managers to run my company and, these managers will be shareholders' agents. These are common relationships in, in modern economies. And there are, are serious problems involved in the principle-agent relationship. Because the principle and the agent might have different incentives, different needs, different priorities, and different preferences. And it's extremely important for principal-agent relationship to be successful to craft this relationship in a way which aligns the incentives of the agent with those of the principle. Otherwise, the principal will suffer and he will refuse to deal with this agent, and the principal-agent relationship would fall apart. And the same problem quite obviously occurs between the society and the government which is about to run this society. And I would say that the principal-agent

problem between the society and the government is actually much more complex than principal-agent problems which arise in the private sector, which are known to be notoriously difficult. So for, for the society to organize it's relations with the government is even more difficult than to do the same thing in the private sector. And I would like to mention, some reasons why this, collective action problem, is is, so difficult to, to, to, to resolve. A couple of problems are kind of technical if you will, important, but technical nonetheless. The first one is that agents are different. If one particular employer hires one particular employee that employer knows what he want, what he wants. In the case of the society vis-a-vis the government we have what is known as a multiple agency problem. In that there are several principles dealing with a single agent. And, these several principles for one, they might have different ideas in mind as to what this agent should do. And, in fact, in modern societies, as you all, too well know. People have vastly different views of what government should be do. How big a government should be. How the government should allocate its resources between the health care system, between the vacation, between the retirement benefits, between child support, so on and so forth. People might have very different, and in fact sometimes sharply conflicting views on that. The second problem is that and it's very unusual, and normally in a principal-agent setting the principal can control and coerce the agent. And when the government is an agent, it's other way around. Because the agent in fact has considerable power of the principle. It can find the principle. It can regulate the principle, it can, individual principles, so to say. So the allocation power in this

principle-agent relationship is opposite to what is common in principle-agent relationships in a private sector. And last but not least, something which is very important to keep in mind when we discuss the relations between governments and society. Is that, there's a little bit of a paradox, of a contradiction, if you will. Make sure you appreciate and realize this paradox. On the one hand, as I was describing governments are brought about to resolve a coordination problem. People do not voluntarily contribute to public good provision as much as they should have. And so here is a government that forces them to make the right contributions. A government which is efficient, which is accountable to the society. Which does not use usurp it's power, is in and of itself, an incredible available public good. And as in every public good provision we have a collective action problem. And as we just saw a, a collective action problem is beset by free-riding. In this particular case, it mean that people are politically passive, but did not participate in, activities, which are supposed to hold government accountable. And sadly, for this particular type of public good, which is efficient and accountable government, there is no super-government that would deliver this public good. And therefore, it's up to the society on its own to be able to resolve this public good. And this is a matter of cultural trades, it's a matter of something which is known as civic culture which exhibits considerable variations from one country to the other. And it is not surprising that these rela, relations are strongly correlated with government performance across the nations. This is a point to which I expect you get back later in this course. [SOUND] [SOUND] [MUSIC]