Externalities and compensation: Primeval games and solutions

The classical literature [Pigou, A.C., 1920. The Economics of Welfare. Macmillan, London; Coase, R.H., 1960. The problem of social cost. Journal of Law and Economics 3, 1-44; Arrow, K., 1970. The organization of economic activity: issues pertinent to the choice of market versus non-market allocation. In: Haveman, R.H., Margolis, J. (Eds.), Public Expenditures and Policy Analysis. Markham, Chicago, pp. 59-73] and the relatively recent studies [cf. Varian, H.R., 1994. A solution to the problem of externalities when agents are well-informed. American Economic Review 84, 1278-1293] associate the externality problem with efficiency. This paper focuses explicitly on the compensation problem in the context of externalities. To capture the features of inter-individual externalities, this paper constructs a new game-theoretic framework: primeval games. These games are used to design normative compensation rules for the underlying compensation problems: the marginalistic rule, the concession rule, and the primeval rule. Characterizations of the marginalistic rule and the concession rule are provided and specific properties of the primeval rule are studied. (C) 2007 Elsevier B.V. All rights reserved.