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Hal R. Varian
The American Economic Review, Volume 84, Issue 5 (Dec., 1994), 1278-1293.
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A Solution to the Problem of Externalities
When Agents Are Well-Informed
By HAL R. VARIAN*
which this assumption may be plausible. For between the agents. Coase claims that if
example, consider a group of agents who transactions costs are zero and property
must design a constitution that describes a rights are well defined, agents should be
mechanism to make group decisions for able to negotiate their way to an efficient
problems that will arise in the future. At the outcome. But this is an incomplete solution
time the mechanism is chosen, the agents to the problem of externalities since Coase
may not know the relevant tastes and tech- does not describe a specific mechanism for
nologies, but they will know these things negotiation. The compensation mechanism
when the mechanism is actually used. In described below provides a structure for
this circumstance, the compensation mecha- such negotiations and therefore can be
nism may be a useful mechanism. See Moore viewed as being complementary to the Coase
and Repullo (1988) and Eric Maskin (1985) approach.
for further discussion of these issues. A second class of solutions, associated
I first describe a very simple example of with Kenneth Arrow (1970), involves setting
the compensation mechanism in a two-agent up a market for the externality. If a firm
externalities problem and discuss in an intu- produces pollution that harms another firm,
itive way why the method works. The fol- then a competitive market for the right to
lowing sections show how the method can pollute may allow for an efficient outcome.
be extended to work in more general envi- From the Coasian point of view, a competi-
ronments. tive market is a particular institution that
allows agents to negotiate their way to an
I. A Simple Example of the Compensation efficient outcome. However, as Arrow points
Mechanism out, the market for allocating a particular
externality may be very thinin many cases
Consider the following externality prob- of interest such markets involve only two
lem involving two agents. For simplicity, participants.
think of each agent as a profit-maximizing However, a thin market does not neces-
firm. Firm 1 produces output x so as to sarily mean a noncompetitive market. There
maximize profit: are both theoretical and empirical reasons
to believe that certain kinds of market inter-
TT1 = rx c( x)
action can be competitive even though only
where r is the competitive price of output a small number of agents are involved. For
and c ( x ) is a differentiable, positive, in- example, a Bertrand model of oligopoly
creasing, and convex cost function. yields a more or less competitive outcome
Firm ls choice of output imposes an ex- with only two firms. The real-life implemen-
ternality on firm 2; in particular, firm 2s tation of Bertrand competitioncompeti-
profits are tive biddingseems to work reasonably
well, even with only a small number of
7T2= ~ e(x) bidders. This suggests that markets for ex-
where e ( x ) is a differentiable, positive, in- ternalities with price-setting agents may be
creasing, and convex function of x . All of a useful model for negotiations among
this information is known to both agents but agents. This is a key insight behind the
is not known by the regulator. In general, compensation mechanism.
the level of output chosen by firm 1 will not A third class of solutions, associated with
be efficient, since firm 1 ignores the social A. C. Pigou (1920), involves intervention by
cost its choice imposes on firm 2. There are a regulator who imposes a Pigovian tax. The
three classic solutions to this problem of difficulty with this solution is that it requires
externalities. the regulator to be able to compute the
One class of solutions, associated with correct level of the Pigovian tax; in many
Ronald Coase (1960) involves negotiation cases the regulator may not have access to
this information, so the Pigovian solution is
also incomplete. The compensation mecha-
1280 THE AMERICAN ECONOMIC REVIEW DECEMBER 1994
nism solves this problem, since it gives the The parameter a x > 0 is of arbitrary mag-
regulator a method to induce the partici- nitude.
pants to reveal the information necessary to
construct the optimal Pigovian tax. In this mechanism, firm 1 is forced to pay
Returning to the example, note that if the a tax based on the marginal social cost of
regulator had full information, internalizing the externality as reported by firm 2, and
the externality would be easy. One solution firm 2 receives compensation based on the
would be for the regulator to impose the marginal social cost of the externality as
costs of the externality on firm 1 by charging reported by firm 1. Firm 1 must also pay a
it a tax of e ( x ) if it produces x units of penalty if it reports a different marginal
output. Firm 1 would then solve the prob- social cost than firm 2 reports. Any penalty
lem that is minimized when the reports are the
max r x c ( x ) e ( x ) . same will work, but I have chosen a
X quadratic penalty for simplicity. Note in
particular that the penalty can be arbitrarily
Let x * be solution to this problem; then x * small.
satisfies the first-order condition
II. Analysis of the Compensation
r - c'(**) - e ' ( x *) = 0. Mechanism
Because of the curvature assumptions on
e ( x \ the regulator could just as well set a There are many Nash equilibria of this
Pigovian tax, p * = e ' ( x * ) and let firm 1 game; essentially any triple ( p l 9 p 2 , x ) such
solve the problem that P i = p2 and x maximizes firm ls ob-
jective function is a Nash equilibrium. How-
max r x c ( x ) p * x . ever, if the stronger concept of subgame-
X
perfect equilibrium is used, there is a much
However, I have assumed that the regula- smaller set of equilibria. In fact, the unique
tor does not know the externality cost func- subgame-perfect equilibrium of this game
tion and therefore cannot determine the has each agent reporting px = p2 = p* and
appropriate value of p*. The regulators firm 1 producing the efficient amount of
problem is to design a mechanism that will output.
induce the agents to reveal their informa- In order to verify this, one must work
tion about the magnitude of the externality backwards through the game. Begin with
and achieve an efficient level of produc- the choice stage. Firm 1 maximizes its prof-
tion. Here is a version of the compensa- its, given the Pigovian tax announced in
tion mechanism that solves the regulators stage 1, which implies that firm 1 will choose
problem. x to satisfy the first-order condition
n2 = P i X e ( x ) . (2) Pi = P2-
VOL. 84 NO. 5 VARIAN: EXTERNALITIES WHEN AGENTS ARE WELL-INFORMED 1281
This is clear since p x only influences firm 2 will be overcompensated for the exter-
ls payoff through the penalty term, and the nalityso it will want firm 1 to produce a
penalty is minimized when p x = p2. large amount of output. But the only way
Consider now firm 2s pricing decision. firm 2 can give firm 1 an incentive to pro-
Although firm 2s announcement has no di- duce a large amount of output is by report-
rect effect on firm 2s profits, it does have an ing a small price for the externality. This
indirect effect through the influence of p2 contradicts the original assumption that firm
on firm ls output choice in stage 2. Differ- 1 thinks that firm 2 will report a large price
entiating the profit function of firm 2 with for the externality. The only equilibrium for
respect to p2, and setting it equal to zero the mechanisms occurs if firm 2 is just com-
yields pensated (on the margin) for the cost that
firm 1 imposes on it; at this point firm 2
(3) n ' 2 ( p 2 ) = [ p l - e ' { x ) \ x ' { p 2 ) = 0 . does not want firm 1 to increase or decrease
its level of production.
Since x ' ( p 2 ) < 0, then it must be that p x =
e'(x). IV. Extensions of the Basic Example
n 3 = P 3i x - e 3 ( x ).
*1 have not considered the possibility of mixed
strategies. However, since the stage-1 game is super-
2
modular and has a unique pure-strategy equilibrium, This idea seems to have been first used by Theodore
the results of Paul Milgrom and John Roberts (1990) Groves and John Ledyard (1977). Since then it has
can be applied to show that there are no mixed-strategy been used by a number of other authors.
equilibria.
1282 THE AMERICAN ECONOMIC REVIEW DECEMBER 1994
(4) nl = r x -c (x ) -[ p l l +p h \ x Pl\)x
-WPII-PI.W-WPII-PU n2 = p h x - e 2 ( x )
\l3 = phx-e3(x).
n2 = p\\X e 2 ( x)
Differentiating with respect to each of the
+ [p|l--P3l] * + 11^31 P3lll choice variables as above shows that the
equilibrium of this mechanism is efficient,
and it is obviously balanced. Each of these
n3 = p\xx -e 3 (x ) ways of balancing the compensation mecha-
+ [ P I I ~ P n \ x + ll^li - P l M nism works in general as I will demonstrate
below.
Straightforward addition shows that this
game is balanced. Using the same sort of B. Adjusting to Equilibrium
arguments as before, it is possible to verify
that the unique equilibrium of this mecha- There is a natural adjustment process for
nism is the efficient outcome. In fact, it is the compensation mechanism that will lead
not necessary to have penalty terms when naive agents to the subgame-perfect equilib-
there are more than two agents. To see this, rium. Suppose that two agents play the game
set the penalty terms in (4) equal to zero repeatedly. In period t +1, agent 1 sets px
and differentiate the relevant objective to be whatever price agent 2 announced last
functions with respect to the choice vari- period, and agent 2 moves p2 in a direction
ables x, p 2i, and p\x: that increases its profits if agent 1 sets the
same price as it did last period. In the
choice stage, agent 1 chooses output to max-
r -c ' ( x ) -[ p l l + p\x\ =0 imize profits, given the current prices. This
leads to a simple discrete dynamical system:
[ P \ I - e i ( x ) + p \ i ~ p \ i] x ' { p h + p h ) = 0
(5) p1(t + l)=p2(t)
[P\i ~ e'z(x) + ph - ph]x'{ph + Ph) = 0. p 2 { t +1) = p2{t) - y[p^t) -
Since the derivatives of x must be nonzero e'(x(p2{t))\.
due to strict convexity of the cost function,
the terms in brackets must be zero. Adding Here y > 0 is a speed-of-adjustment param-
the bracketed expressions in the last two eter. The differential-equation analogue of
equations together and substituting into the this system is
first equation shows that the equilibrium is
efficient. (6) P\ = p 2 P\
Yet a third way to balance the mecha-
nism is to allow agent 2 to name the cost Pi--y[Pi-e'(x{p2))\.
that agent 1 imposes on agent 3 and vice It is easy to show that that (6) is locally
versa. This is a bit less natural in terms of stable; the difference-equation version de-
the information requirements, but it yields a scribed in (5), will be locally stable if y is
small enough to avoid overshooting. Note
that if the agents use this adjustment proce-
dure neither one needs to know anything
about the other agents technology. All that
VOL. 84 NO. 5 VARIAN: EXTERNALITIES WHEN AGENTS ARE WELL-INFORMED 1283
information is subsumed in the price mes- However, in the announcement stage, firm
sages that the agents send back and forth.3 2 can induce any level of x that it wants by
appropriate choice of the function e 2 .
C. Nonlinear Taxes and Compensation Hence, the equilibrium choice of x must
Functions also maximize firm 2s profits:
The basic compensation mechanism de- (8) i(x*) - e ( x * ) > e x ( x ) - e ( x )
scribed above uses linear pricing. Linear
prices are fine in a convex environment, but for all x .
if the environment is not convex, linear
prices will not in general be able to support Adding (7) and (8) together, and using the
efficient allocations. However, this difficulty fact that e 1 ( x ) = e 2 ( x ) in equilibrium, one
is no problem for a suitable generalization obtains
of the compensation mechanism. (9) rx* - c(x*)- e(x*) > rx - c(x)~ e(x)
Announcement stage.Firm 1 and 2 each for all x
announce the externality cost function for
which shows that x* is the socially optimal
firm 2. Call these announcements e x ( - )
amount.
and e 2 ( ) .
This argument shows that all equilibria of
Choice stage.Firm 1 chooses x, and each the mechanism are efficient. However, in
firm receives payoffs given by general there will be many equilibria of this
Y i l { x ) = r x - c ( x ) - e 2 ( x ) - \\ex - game. To see this, observe that if e x and e 2
e2\\ are equilibrium announcements, so are e x +
F and e 2 + F for arbitrary values of F . In
II2(x) = e i ( x ) e ( x ) . order to get uniqueness of equilibrium, it is
necessary to restrict the class of allowable
messages.4
Here \\el e2\\ signifies any norm in the One way to do this is to parameterize the
appropriate function space. All that is cost function.5 Suppose that the set of pos-
required is that it is minimized when both sible externality costs is e ( x , t ) where t is a
agents report the same function. real-valued index of type. Suppose that the
To see that this works, simply note that in true type of firm 2 is t 0 . In the announce-
equilibrium firm 1 will always want to report ment stage of the game, each firm simply
the same function as firm 2, so e^x) = e 2 ( x ) . announces the type of firm 2, and firm 1
Maximization of profit by firm 1 in the choice pays a penalty if its announcement is dif-
stage implies ferent from that of firm 2. If t x is firm ls
announcement and t 2 is firm 2s announce-
(7) r x * - c ( x * ) - e 2 ( x * ) ment, the payoffs will be
2
> r x - c ( x ) - e 2 ( x ) for all x . U^x) = rx c(x) e(x,t2)
(t1 t2)
U 2 ( x ) = e ( x , t 1 ) - e ( x , t 0)
3
This is, of course, a very special adjustment pro-
cess. However, Milgrom and Roberts (1991) show that
4
for dominance-solvable games every adjustment pro- One could also refine the solution concept. In this
cess consistent with adaptive or sophisticated learning example it may be reasonable for agent 1 to assume
converges to the dominance-solvable equilibrium. that agent 2 will announce the largest possible value of
Hence it may be reasonably be expected that a wide F consistent with agent ls participation.
5
class of adjustment mechanisms will work when the In the convex case one can think of the efficiency
second-stage game is dominance-solvable (as it is in prices as being a particularly convenient parameteriza-
this case). tion for the type space.
1284 THE AMERICAN ECONOMIC REVIEW DECEMBER 1994
d e ( x , t 0) du1/dx1 du2/dxx
r = c'( x ) + (10)
dx du1/dy1 du2/dy2
Choice stage.Each agent chooses xt and simplicity, the first-order conditions are:
yt so as to maximize utility subject to a
budget constraint:
maxw^jCj, x 2 , y i )
*\>y\
such that
and
such that
The above proof shows clearly why an p\2x2 + y2 = w2 + p12lxl - \\p\2 - p\2II.
equilibrium of the compensation mecha-
nism must be an efficient allocation. How- Note that agent 1 can influence agent 2s
ever, being a calculus proof, it does not deal choice of x2 through both the income
very well with corner solutions, additional term, p \ x x v and the price term, p\2.
constraints, nondifferentiabilities, and the However, by Assumption 1, any choice of
like. Here is another argument that handles x2 that can be achieved through the income
these difficulties easily. term can also be achieved by an appropriate
I need one assumption for the proof, an choice of the price term, p\2.
invertibility assumption that says that each Suppose that there were an equilibrium
agent can set a price for the other agent in which /?2i ^ P\V Let agent 1 set p\x = p\x
that will induce the other agent to make any and adjust p\2 so as to induce the original
desired choice. That is, if agent 1 would like equilibrium value of x2. This must reduce
agent 2 to make some choice, there is some agent ls penalty and thereby increase agent
price that agent 1 can set that will induce ls utility. This contradicts the assumption
agent 2 to make this choice. This is analo- that there is an equilibrium. It follows that
VOL. 84 NO. 5 VARIAN: EXTERNALITIES WHEN AGENTS ARE WELL-INFORMED 1287
an equilibrium must exhibit zero penalty anced by distributing the budget surplus
terms for all agents. generated by each agent among the other
Suppose now that ( x ' , y ' ) is a feasible agents. The same procedure works in gen-
allocation that Pareto-dominates the equi- eral; here I examine the simple case of
librium allocation. I will show that the exis- quasi-linear utility.
tence of such an allocation leads to a con- The appropriate payoff to agent i is
tradiction. By convexity and continuity of
n
preferences, one can assume that (JC% y') is ,(*)+ E B i j ~ T
,
arbitrarily close to the equilibrium alloca- i =i
tion. According to Assumption 1, agent 1
can induce agent 2 to choose x 2 simply by where
choosing an appropriate level of p \2; fur-
thermore, agent 1 can directly choose
(jci, yi). If agent 1 decides n o t to choose
B
u = piixi - pjixi -1Ipj. - pjiII
this preferred allocation, it must be because
it lies outside his budget set. The same
argument applies to agent 2, and this gives
the inequalities
Summing these inequalities and using the It is obvious that Bu = 0, and it is not hard
fact that pln = pji9 one obtains to show that
y'i + y2 > + w2
n
which shows that the Pareto-dominating al-
location must be infeasible. (17) E E Bij - Ti = o.
i=l i -1
for all x . Summing over the agents and of person k about the appropriate magni-
using equation (17) yields tude of the price p i j 9 and let x = (JC1? x 2 , x 3 )
be the vector of choices.
In this variant of the compensation mech-
E w,(**)> E /(*) anism, the payoffs to the agents will be:
i =1 /=1
(18) !(*)-( p h + P2l)*l + P 12*2 + Pl3*3
for all x , which shows that the subgame-
perfect equilibrium is Pareto efficient. u 2 (x ) ~ (p \ 2 + p \ 2 ) x 2 + p\lx1 + p\3x3
Note that this argument does not use the Ul (x ) - (P23 + Pl d X 3 + >31*1 + P\lx2-
linear structure of the B ^i x) terms; indeed,
the only feature used is that agent j can Note that the payoffs are balanced, even out
report a B t j (x ) term that will induce agent i of equilibrium. No sidepayments or penal-
to make the choice x t that agent j wants ties are necessary in this case.
him to make. In a convex environment lin- One way to prove that the subgame-per-
ear prices will generally have this property, fect equilibrium is efficient is to differenti-
but in other environments other sorts of ate the payoffs with respect to each of the
pricing functions may be necessary. choice variables. However, one can also ap-
Note further that this argument for effi- ply the logic of the previous section. Simply
ciency does not use the penalty terms; if all replace the definitions used there with
the penalty terms are set equal to zero, the
proof of efficiency still goes through. How- B ? j ( X ) = p?jXj-p?ixi
ever, the penalty terms will in general be
necessary if the equilibrium allocation is to Ux) = o
be a Lindahl allocation. Why? In order to where k takes on all possible values 1 , . . . , n ,
be a generalized Lindahl allocation each but k = i , j . Note that when n = 3 these are
agent must satisfy his budget constraint the payoffs given in (18). These definitions
when each choice is priced at its supporting imply that
efficiency price. For this to be the case, the
T t ( x) term must be zero in equilibrium. If
the penalty terms are present, each agent *5(*)-
will have an incentive to set p 1 ^ = p j , which i=iy=i
will ensure that this will occur.
and this is all that is required for the
VII. A Different Information Structure proof given in the previous section to work.
The compensation mechanism described The resulting allocation is automatically
above is appropriate for a bilateral infor- Lindahl.
mation structure: if agent i imposes costs on
VIII. Examples of the Compensation
agent j , both i and j know the magnitude
Mechanism
of these costs. Another structure that one
might imagine is that there is some third I have described the general form of the
party, k , who knows the magnitude of these compensation mechanism; here I illustrate
costs. In this case, one can use a slightly how it works in some specific cases.
different type of compensation mechanism
to achieve efficient outcomes. A. Pure Public Goods
Consider the following example with three
agents. Agent i chooses x i 9 holds money The special case of a pure public good is
y i 9 and has a quasi-linear utility function of some interest, since it is a well-known
u i (x 1 , x 2 , x 3 ) +y i . The prices that support
an efficient allocation will have the form
Pu = d u i ( x )/ d x j . Let p i denote the report
VOL. 84 NO. 5 VARIAN: EXTERNALITIES WHEN AGENTS ARE WELL-INFORMED 1289
Announcement stage.The consumer an- for each firm to report the price that the
nounces how much he values the good, other firm should face. This yields payoffs of
pv and the producer announces how much the form
the consumer values the good, p2.
Choice stage.The producer chooses x, and n0 = u(x x , X 2 ) - pl x X x - P o 2 x 2
the payoffs are
Hi =P m x i -c l (x l )
Ui = u ( x ) p 2 x
^2 = P02X2~C2(X2)-
n2 = p x x - c( x )- \\p 2 - p x \\.
Note that the consumer chooses both x x
and x 2 and that each firm sets the price for
the other firms product.
Note that this problem is very similar to The arguments given earlier show that
the simple externalities problem used to the competitive allocation is the unique
motivate the compensation mechanism, il- equilibrium of this game. But it is useful to
lustrating the Coasian point that externali- think about how it works here. Consider the
ties are just a special case of private goods.7 classic Bertrand cases in which the two
Applying the standard argument shows that goods are perfect substitutes. Suppose that
in equilibrium each firm has announced the competitive
price. Why would firm 1 not want to raise
px = p2 = u\x) = c'(x) the price of firm 2s product, creating more
demand for its own output? If firm 1 raised
which are the conditions that characterize the price facing firm 2, then the consumer
the competitive allocation. would demand more output from firm 1,
which it would be forced to supply. But
C. Regulation of Duopoly since the price that firm 1 faces equals its
marginal cost, this would reduce firm ls
There are now three agents: the con- profit.
sumer (indexed by 0) and two firms. Firm 1
produces xx at cost c f x f ) , firm 2 produces D. Prisoner's Dilemma
x 2 at cost c 2 ( x 2 ), and the consumer has
utility function u ( x x , x 2 ) + y 0 . The Consider the following asymmetric pris-
standard oners dilemma:
compensation mechanism involves payoffs
of the form Column
Row Cooperate Defect
Il0 = u ( x x , X 2 ) - p\ x X x - P Q 2 x 2
Cooperate 5,5 2,6
n
i = P o i x i ~ c i ( x i ) - IIPoi - Poill Defect 7,1 3,3
n2 = P Q 2 X 2 - C
2 i X 2 ) - \\P02 - How can one induce the Pareto-efficient
outcome? Let JK, = 1 if agent i cooperates
PoiW- and xt = 0 if agent i defects, and let
Here the consumer is setting the prices that u f x x , x 2 ) be the payoff to agent i taken
the firms face, and the firms are setting the from the above game matrix.
prices that the consumer faces.
However, in the case of duopoly it is Announcement stage.Agent 1 names p\2,
natural to think that the firms may know how much agent 1 should be paid if he
more about each others technology than cooperates, and p\l9 how much agent 2
the consumer knows. Hence it makes sense
7
Or is it the other way around?
VOL. 84 NO. 5 VARIAN: EXTERNALITIES WHEN AGENTS ARE WELL-INFORMED 1291
p\x2.
U i = u 1(x 1,x 2 ) + P2 1 X 1 ~ P 12*2 In this game, each agent sets the rate at
which he will subsidize the other agents
- \ \ p \ i ~ p\i\\ cooperation. As in the other games exam-
ined, the subgame-perfect equilibrium yields
an efficient outcome. It has long been known
n2 = u2Oi> x2) + p\2x2 - p121xl that the ability to make binding preplay
commitments allows for a solution to the
-\\ P 2- P n\l prisoners dilemma. What is interesting
Note the sign change: since there is now a about this example is how simple the first-
positive externality between the two agents, stage commitments can be and still support
it is natural to subsidize good behavior efficient outcomes.
rather than to penalize bad behavior.8 Us-
ing the by now standard argument, it can be IX. Related Literature
shown that it is a subgame-perfect equilib- There is a vast literature on mechanism
rium for both players to cooperate. The design that is concerned with how to imple-
supporting prices satisfy the conditions ment various social-choice functions. Much
of this literature is concerned with whether
4 > p\i = p\i > 2 a particular social-choice function can be
implemented by a decentralized game. My
3 ^ P12 = Pl2 1* concern is not so much with the existence of
a mechanism, but rather finding a suitably
(If the inequalities are strict, the coopera- simple mechanism. Most of the attempts to
tive equilibrium will be unique.) As usual, find simple solutions to externalities
the compensation mechanism produces an problems have been concerned with the case
efficient outcome in this gameor in any of public goods, so I provide a very brief
game, for that matter. However, the pris- review of that literature insofar as it relates
oners dilemma has a special structure, and to the work described here. Moore (1992)
it turns out that a related, but simpler, provides a thorough review of the recent
mechanism is available. literature.
The well-known demand-revealing mech-
Announcement stage.Agent 1 names p\, anism of Edward Clarke (1971) and
how much he is willing to pay agent 2 to Theodore Groves (1976) implements the
cooperate, and agent 2 names p\, how efficient amount of a public good via a dom-
much agent 2 is willing to pay agent 1 to inant strategy equilibrium. However, this
cooperate. mechanism only works with quasi-linear
Choice stage.Each agent chooses whether utility, and it is not balanced, even in equi-
to cooperate or defect. The agents re- librium. Furthermore, it does not in general
yield a Pareto-efficient outcome.
Groves and John Ledyard (1977) describe
a quadratic mechanism that yields efficient
Nash equilibria for the public-goods prob-
lem, but the equilibrium allocations are not
8
One could also formulate this problem so as to Lindahl allocations. Leo Hurwicz (1979) and
have each agent announce how the other agent should Mark Walker (1981) also describe mecha-
be fined if he defects.
1292 THE AMERICAN ECONOMIC REVIEW DECEMBER 1994
nisms that implement Lindahl allocations. problems involving many agents and general
In the Hurwicz mechanism, each agent pro- utility functions.
poses an amount of the public good and a
Lindahl price; agents pay a quadratic penalty X. Summary
if they announce different levels of the pub-
lic good. Walkers mechanism avoids such The compensation mechanism provides a
penalty terms. Groves (1979) and Groves simple mechanism for internalizing exter-
and Ledyard (1987) provide a nice survey of nalities in economic environments. Transfer
these results. payments can be chosen so that the com-
Turning to the more recent literature on pensation mechanism is balanced, and
simple mechanisms, Mark Bagnoli and Bart penalty payments, when they are used, can
Lipman (1994) and Matthew Jackson and be chosen to be arbitrarily small. The main
Herv Moulin (1992) examine the special problem with the mechanism is that it re-
case of a discrete public good with quasi- quires complete information by the agents.
linear utility. The Bagnoli-Lipman mecha- In many cases, a simple dynamic adjustment
nism is very simple: each agent offers a model will converge to the subgame-perfect
voluntary contribution. If the sum of the equilibrium.
contributions covers the cost of the public
good, it is produced; otherwise the contri-
butions are returned. This mechanism im- REFERENCES
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9
This mechanism is related to the mechanism of Mechanism. European Journal of Politi-
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