Decentralization, externalities, and efficiency

Peter Klibanoff, Jonathan Morduch

Research output: Contribution to journalArticlepeer-review


In the competitive model, externalities lead to inefficiencies, and inefficiencies increase with the size of externalities. However, as argued by Coase, these problems may be mitigated in a decentralized system through voluntary coordination. We show how coordination is limited by the combination of two factors: respect for individual autonomy and the existence of private information. Together they imply that efficient outcomes can only be achieved through coordination when external effects are relatively large. Moreover, there are instances in which coordination cannot yield any improvement at all, despite common knowledge that social gains from agreement exist. This occurs when external effects are relatively small, and this may help to explain why coordination is so seldom observed in practice. When improvements are possible, we describe how simple subsidies can be used to implement second-best solutions and explain why standard solutions, such as Pigovian taxes, cannot be used. Possible extensions to issues arising in the structure of research joint ventures, assumptions in the endogenous growth literature, and the location of environmental hazards are also described.

Original languageEnglish (US)
Pages (from-to)223-247
Number of pages25
JournalReview of Economic Studies
Issue number2
StatePublished - Apr 1995

ASJC Scopus subject areas

  • Economics and Econometrics


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