Skip to main content
SpringerLink
Log in

Economics of Externalities: An Overview

  • Reference work entry
  • First Online:
Handbook of Production Economics

Abstract

Externalities arise when the decisions of an agent have direct effects on the welfare of others. This chapter presents an overview on the economics of externalities. Relying on Pareto efficiency, the analysis is presented in a general equilibrium framework and evaluates the efficient management of externalities. The investigation also focuses on the role of non-convexity and transaction costs. It covers alternative institutional setups, including markets, government interventions, and contracts. It reexamines how efficient management of externalities remains consistent with aggregate profit maximization under transaction costs and non-convexity. It indicates how pricing can support an efficient allocation under externalities, but this may require nonlinear pricing under non-convexity. And it explores how the minimization of transaction costs is an integral part of the efficient management of externalities.

The author would like to thank two anonymous reviewers for useful comments on an earlier draft of the chapter.

This is a preview of subscription content, log in via an institution to check access.

Access this chapter

Log in via an institution
Chapter
USD 29.95
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
eBook
USD 339.00
Price excludes VAT (USA)
  • Available as EPUB and PDF
  • Read on any device
  • Instant download
  • Own it forever
Hardcover Book
USD 899.99
Price excludes VAT (USA)
  • Durable hardcover edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info

Tax calculation will be finalised at checkout

Purchases are for personal use only

Institutional subscriptions

Similar content being viewed by others

Notes

  1. 1.

    In case where Pigouvian taxes/subsidies are not fiscally neutral, attaining efficiency requires redistribution of any fiscal surplus/deficit to consumers through lump sum payments [1, 3, 5]. Otherwise, Pigouvian taxes would not achieve “first-best” efficiency.

  2. 2.

    As discussed below, government intervention can still be helpful to achieve efficiency through quantity regulations and/or through nonlinear pricing policies.

  3. 3.

    Other options include individual transferable permits/quotas [25], and Varian [26]’s scheme involving a two-step mechanism that can implement efficient allocations as subgame-perfect equilibria under externalities.

  4. 4.

    Note that equity considerations (not addressed in this chapter) can also play a role in evaluating alternative externality management strategies.

  5. 5.

    In this context, when comparing government pricing policies versus government standards/quotas, economists often follow Pigou [5] and argue in favor of pricing policies on the ground that they are easier to implement and require less information (especially in the presence of heterogeneous agents). These issues are further discussed in Sect. 4.

  6. 6.

    Equation (3) includes as a special case the situation where there is no consumption externality, in which case individual benefit can be evaluated one consumer at a time and aggregate benefit is just the sum of individual benefits across all consumers [30, 31].

  7. 7.

    The conditions needed for the existence of a saddle-point in (6) are mild and are expected to hold under fairly general conditions. See Gould [38], Bertsekas [36], and Chavas and Briec [13]. In this chapter, we assume that these conditions hold.

  8. 8.

    Note that, under convexity and in the absence of externalities, the analysis would then reduce to the standard welfare theorems establishing close relationships between Pareto efficiency, decentralized decisions, and competitive markets (e.g., [7, 43]).

  9. 9.

    The line (G E2 G’) in Fig. 4 implies that the relative price (p2/p1) declines with y2, indicating that the price p2 decreases with y2. This is a situation of “volume discount” commonly observed in nonlinear pricing (e.g., [44]).

References

  1. Baumol WJ, Oates WE (1988) The theory of environmental policy, 2nd edn. Cambridge University Press, Cambridge

    Book  Google Scholar 

  2. Laffont JJ (2008) Externalities. In: Durlauf S, Blume LE (eds) The new Palgrave dictionary of economics, 2nd edn. Palgrave Macmillan, London

    Google Scholar 

  3. Baumol WJ (1972) On taxation and the control of externalities. Am Econ Rev 62:307–322

    Google Scholar 

  4. Cornes R, Sandler T (1996) The theory of externalities, public goods and club goods. Cambridge University Press, Cambridge

    Book  Google Scholar 

  5. Pigou AC (1920) The economics of welfare. Macmillan, London

    Google Scholar 

  6. Coase RH (1960) The problem of social cost. J Law Econ 3:1–44

    Article  Google Scholar 

  7. Debreu G (1959) Theory of value. Wiley, New York

    Google Scholar 

  8. Arrow K (1969) The organization of economic activity: issues pertinent to the choice of market versus non-market allocation. In: The analysis and evaluation of public expenditures: the PPB system. Government Printing Office, Washington, DC

    Google Scholar 

  9. Starrett D (1972) Fundamental non-convexities in the theory of externalities. J Econ Theory 4:180–199

    Article  Google Scholar 

  10. Baumol WJ, Bradford DF (1972) Detrimental externalities and non-convexity of the production set. Economica 39:160–176

    Article  Google Scholar 

  11. Dasgupta P, Maler KG (2003) The economics of non-convex ecosystems: introduction. Environ Resour Econ 26:499–525

    Article  Google Scholar 

  12. Brown DJ (1991) Equilibrium analysis with non-convex technologies. In: Hildenbrand W, Sonnenschein H (eds) Handbook of mathematical economics, vol 4. Elsevier, Amsterdam

    Google Scholar 

  13. Chavas JP, Briec W (2012) On efficiency under non-convexity. Econom Theor 50:671–701

    Article  Google Scholar 

  14. Guesnerie R (1975) Pareto optimality in non-convex economies. Econometrica 43:1–29

    Article  Google Scholar 

  15. Khan MA (1999) The Mordukhovich normal cone and the foundations of welfare economic. J Public Econom Theor 1:309–338

    Article  Google Scholar 

  16. Khan MA, Vohra R (1987) An extension of the second welfare theorem to economies with nonconvexities and public goods. Q J Econ 102:223–242

    Article  Google Scholar 

  17. Mordukhovich BS (2005) Nonlinear prices in nonconvex economies with classical pareto and strong Pareto optimal allocations. Positivity 9:541–568

    Article  Google Scholar 

  18. Chavas JP (2015) Coase revisited: economic efficiency under externalities, transaction costs and non-convexity. J Inst Theor Econ 171:709–734

    Article  Google Scholar 

  19. Coase RH (1937) The nature of the firm. Economica 4:386–405

    Article  Google Scholar 

  20. Foley DK (1970) Economic equilibrium with costly marketing. J Econ Theory 2:276–291

    Article  Google Scholar 

  21. Hahn FH (1971) Equilibrium with transaction costs. Econometrica 39:417–439

    Article  Google Scholar 

  22. Williamson OE (1989) Transaction cost economics. In: Handbook of industrial organization, vol 1. North Holland, Amsterdam

    Google Scholar 

  23. Williamson OE, Winter SG (eds) (1991) The nature of the firm, origins, evolution, and development. Oxford University Press, Oxford

    Google Scholar 

  24. Shleifer A (2010) Efficient regulation. Working paper no. 15651, National Bureau of Economic Research, Cambridge, MA

    Google Scholar 

  25. Stavins RN (1995) Transaction costs and tradeable permits. J Environ Econ Manag 29:133–148

    Article  Google Scholar 

  26. Varian HR (1994) A solution to the problem of externalities when agents are well-informed. Am Econ Rev 84(1994):1278–1293

    Google Scholar 

  27. Coase RH (1992) The institutional structure of production. Am Econ Rev 82:713–719

    Google Scholar 

  28. Radner R (1968) Competitive equilibrium under uncertainty. Econometrica 36:31–58

    Article  Google Scholar 

  29. Luenberger DG (1995) Externalities and benefits. J Math Econ 24:159–177

    Article  Google Scholar 

  30. Luenberger DG (1992a) New optimality principles for economic efficiency and equilibrium. J Optim Theory Appl 75:221–264

    Article  Google Scholar 

  31. Luenberger DG (1992b) Benefit functions and duality. J Math Econ 21:461–481

    Article  Google Scholar 

  32. Allais M (1981) La Théorie Générale des Surplus. Economies et Sociétés Institut des Sciences Mathématiques et Economiques Appliquées, Paris

    Google Scholar 

  33. Helfand GE, Rubin J (1994) Spreading versus concentrating damages: environmental policy in the presence of nonconvexities. J Environ Econ Manag 27:84–91

    Article  Google Scholar 

  34. Dixit AK, Norman V (1980) Theory of international trade: a dual general equilibrium approach. Cambridge University Press, London

    Book  Google Scholar 

  35. Luenberger DG (1994) Dual Pareto efficiency. J Econ Theory 62:70–85

    Article  Google Scholar 

  36. Bertsekas DP (1995) Nonlinear programming. Athena Scientific, Belmont

    Google Scholar 

  37. Takayama A (1985) Mathematical economics, 2nd edn. Cambridge University Press, Cambridge

    Google Scholar 

  38. Gould FJ (1969) Extensions of Lagrangian multipliers in nonlinear programming. SIAM J Appl Math 17:1280–1297

    Article  Google Scholar 

  39. Rosen S (1974) Hedonic prices and implicit markets: product differentiation in pure competition. J Polit Econ 82:34–55

    Article  Google Scholar 

  40. Ekeland I, Heckman JJ, Nesheim L (2004) Identification and estimation of hedonic models. J Polit Econ 112:S60–S109

    Article  Google Scholar 

  41. Stigler GJ (1989) Two notes on the Coase theorem. Yale Law J 99(3):631–633

    Article  Google Scholar 

  42. Hurwicz L (1999) Revisiting externalities. J Public Econom Theor 1(2):225–245

    Article  Google Scholar 

  43. Mas-Colell A, Whinston MD, Green J (1995) Microeconomic theory. New York, Oxford university press

    Google Scholar 

  44. Wilson RB (1993) Nonlinear pricing. Oxford University Press, Oxford

    Google Scholar 

  45. Papandreou AA (2003) Externalities, convexity and institutions. Econ Philos 19:281–309

    Article  Google Scholar 

  46. Salanié B (1999) The economics of contracts. The MIT Press, Cambridge, MA

    Google Scholar 

  47. Tirole J (1999) Incomplete contracts: where do we stand? Econometrica 67:741–781

    Article  Google Scholar 

  48. Fabrizio KR, Rose NL, Wolfram CD (2007) “Do markets reduce costs”? Assessing the impact of regulatory restructuring on US electric generation efficiency. Am Econ Rev 97(4):1250–1277

    Article  Google Scholar 

  49. Borenstein S (2012) The redistributional impact of nonlinear electricity pricing. Am Econom Rev Econom Policy 4(3):56–90

    Article  Google Scholar 

  50. Borenstein S, Bushnell JB (2018) Do two electric pricing wrongs make a right? Cost recovery, externalities and efficiency. Working paper 24756, National bureau of economic research, Cambridge, MA

    Google Scholar 

  51. Dutta G, Mitra K (2017) A literature review on dynamic pricing of electricity. J Oper Res Soc 68:1131–1145

    Article  Google Scholar 

  52. Joskow PL, Wolfram CD (2012) Dynamic pricing of electricity. Am Econ Rev 102(3):381–385

    Article  Google Scholar 

  53. Sandler T (2017) Environmental cooperation: contrasting international environmental agreements. Oxford Econ Pap 69(2):345–364

    Google Scholar 

  54. Haas PM (1991) Policy responses to stratospheric ozone depletion. Glob Atmos Change 1(3):224–234

    Article  Google Scholar 

  55. Morrisette PM (1989) The evolution of policy responses to stratospheric ozone depletion. Nat Resour J 29(3):794–820

    Google Scholar 

  56. Solomon S, Ivy DJ, Kinnison D, Mills MJ, Neely RR III, Schmidt A (2016) Emergence of healing in the Antarctic ozone layer. Science 353(6296):269–274

    Article  Google Scholar 

  57. Joskow PL, Schmalensee R (1998) The political economy of market-based environmental policy: the U.S. acid rain program. J Law Econ 41(1):37–84

    Article  Google Scholar 

  58. Stavins RN (1998) What can we learn from the grand policy experiment? Lessons from SO2 allowance trading. J Econom Perspect 12(3):69–88

    Article  Google Scholar 

  59. Chan HR, Chupp BA, Cropper ML, Muller NZ (2018) The impact of trading on the costs and benefits of the acid rain program. J Environ Econ Manag 88:180–209

    Article  Google Scholar 

  60. Nordhaus W (2019) Climate change: the ultimate challenge for economics. Am Econ Rev 109(6):1991–2014

    Article  Google Scholar 

  61. Velders GJM, Andersen SO, Daniel JS, Fahey DW, McFarland M (2007) The importance of the Montreal protocol in protecting climate. Proc Natl Acad Sci 104(12):4814–4819

    Article  Google Scholar 

  62. Patt A, Lilliestam J (2018) The case against carbon prices. Joule 2:2494–2498

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. University of Wisconsin, Madison, WI, USA

    Jean-Paul Chavas

Authors
  1. Jean-Paul Chavas
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Jean-Paul Chavas .

Editor information

Editors and Affiliations

  1. Department of Economics, University of Connecticut, Storrs, CT, USA

    Subhash C. Ray

  2. Department of Agricultural and Resource Economics, University of Maryland, College Park, MD, USA

    Robert G. Chambers

  3. Department of Economics, Binghamton University, Binghamton, NY, USA

    Subal C. Kumbhakar

Rights and permissions

Reprints and permissions

Copyright information

© 2022 Springer Nature Singapore Pte Ltd.

About this entry

Check for updates. Verify currency and authenticity via CrossMark

Cite this entry

Chavas, JP. (2022). Economics of Externalities: An Overview. In: Ray, S.C., Chambers, R.G., Kumbhakar, S.C. (eds) Handbook of Production Economics. Springer, Singapore. https://doi.org/10.1007/978-981-10-3455-8_13

Download citation

Publish with us

Policies and ethics

Search

Navigation