SFB 303 Discussion Paper No. A - 313

Author: Schweizer, Urs
Title: Liberty of Contract versus Coercion through Rules
Abstract: External effects are traditionally claimed to give rise to a discrepancy between private and social benefits which, in turn, prevents the involved parties from achieving a first best solution. The government is then called in to provide the proper remedies. The traditional argument does not stand firm under scrutiny as it relies on noncooperative behavior of, in essence, the Prisoners' Dilemma type without however giving much thought to the implicit assumption of the paradigm which has parties sitting in separate cells. The paradigm need not fit. Moreover, even if it does, the government may face similar difficulties in penetrating the walls while administering the corrective measure. The present paper advocates the view to specify the assumption of the paradigma in contractual terms. The approach allows to explore the tradeoff between market and policy failure in a framework which is well balanced in that it has all institutional arrangements operating in the same environment as far as the setting of transaction costs is concerned.
Keywords: bilateral externalities, market failure, policy failure, constitutional choice
JEL-Classification-Number: 025
Creation-Date: September 1990
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