Choice overload, coordination and inequality: three hurdles to the effectiveness of the compensation mechanism?
We test the effectiveness of a compensation mechanism, adapted from Varian (Am Econ Rev 84(5):1278–1293, 1994). When a negative externality is produced the mechanism allows agents suffering from it to compensate those who reduce its production, by way of transfers implemented via a two-stage design. We investigate various factors that might affect the likelihood that subjects coordinate on a Pareto optimum: the size of the strategy space, the number of subgame perfect equilibria and inequality of the payoff distribution. Our experimental findings suggest that the mechanism’s effectiveness crucially depends on the final payoff distribution (after transfers). It is also strongly negatively affected by the size of the strategy space. Finally, the impact of the number of equilibria on coordination only has a weak negative effect.
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