The characterization of efficiency presented above is very general. It applies in the presence of uncertainty, asymmetric information, transaction costs, public goods, as well as externalities. At this point, it is silent about the role of markets. This indicates that efficiency can be obtained without markets. This is the domain of contracts and policy. Indeed, the state-dependent decision rules z ^e = ( q( e), h( e), x( e), y( e), t( e)) can be the ones specified in a contract or in a policy rule. They can involve production decisions x( e), trade and transfers t( e) with associated transaction resources h( e), as well as the provision of public goods q( e).

What are the distinguishing features of a contract compared to a policy rule? A contract typically involves a relatively small number of individuals who bargain with each other to set up decentralized decision rules. In contrast, policy rules typically involve decisions made by centralized institutions (e.g., government) and affecting a large number of individuals. Thus, both the identity of the decision-makers and the level of centralization differ.

Contracts can play an important role in establishing efficient resource allocation. For example, Coase (1960) has shown that externality problems can be managed through bargaining among the individuals affected. The outcome of bargaining generates individual rights and obligations set out in a contract. Coase argued that,...