iff

complete set of markets exist

property rights are welldefined
no externalities
no strategic behaviour
perfect information
Three conditions must be met for Pareto optimality:
Efficient consumption MRS MRS
A B
12 12 , ,

Efficient production MRTS MRTS

12
1
12
2
, ,

Efficient product mix MRS MRT

12 12 , ,

First Welfare Theorem: CE are PO

Theory of Externalities
General Equilibrium Model
Consider an economy with
x
i
two consumption goods indexed by i = 1,2 consumed by representative
consumer
two production goods indexed by i = 1,2, produced by two firms indexed y
i
k
by k = 1,2, where superscripts denote identity of firm and subscripts
denote type of good
There are two externalities affecting firm 2:
one generated by consumers consumption of good 1, x
1
one generated by production of good 1 by firm 1, y
1
1
Illustrative example: pollution of a river by city inhabitants (municipal
sewage) and a firm (industrial effluents) that affect a
downstream waterusing firm
Consumer
U() is differentiable, increasing and strictly U x x ( , )
1 2
quasiconcave
initial endowment ( , )
1 2
Producers
firm 1's production technology, where is firm 1's y f y
1
1 1
2
1
( ) y
1
1
output, is differentiable and concave and is firm f
1
y
2
1
1's input (negative output) of good 2
firm 2's production technology, where is firm 2's y f y y x
2
2 2
1
2
1
1
1
( , , ) y
2
2
output, is differentiable and concave, is firm 2's f
2
y
1
2
input (negative output) of good 1, is firm 1's output y
1
1
of good 1 and x
1
is consumers consumption of good 1
= inputs = negative outputs y y
2
1
1
2
,
Since inputs have negative sign

f
y
f
y
1
2
1
2
1
2
0 0 ,
Hence, firm 1's production of good 1 and consumers consumption of good
1 both enter firm 2's production function, generating two negative externalities.
Pareto Optimal Allocation
{ }
max ( , )
, , , , ,
( )
( , , )
U x x
x x y y y y
y y x
y y x
y f y
y f y y x
1 2
1 2 1
1
2
1
2
2
1
2
1
1
1
2
1 1
2
1
2
2
2 2
1
1 1
2
1
2
2 2
1
2
1
1
1
0
0
0
0
s.t.
scarcity contraints
technological constraints
+ +
+ +

+
+

We can ignore the inequality constraints because of the convexity and concavity
assumptions these assumptions are sufficient conditions for interior solutions.
The Lagrangian can be written as
{ }
( ) ( )
( ) ( )
max
, , , , ,
( , )
( ) ( , , )
x x y y y y
L U x x y y x y y x
y f y y f y y x
1 2 1
1
2
1
2
2
1
2
1 2 1 1
1
1
2
1 1 2 2
1
2
2
2 2
1 1
1 1
2
1
2 2
2 2
1
2
1
1
1
+ + + + + +
+ + + +


(1)

L
x
U
x
f
x
1 1
1 2
2
1
0 +
(2)

L
x
U
x
2 2
2
0
(3)

L
y
f
y
1
1 1 1 2
2
1
1
0 +
(4)

L
y
f
y
2
1 2 1
1
2
1
0 +
(5)

L
y
2
2 2 2
0
(6)

L
y
f
y
1
2 1 2
2
1
2
0 +
Solution
Eliminate . Express efficiency conditions in terms of .
1 2
and

1
2
Efficient consumption
Rewrite equations (1) and (2). Substitute from equation (5):
2 2

(1)

1
1
2
2
1
+
U
x
f
x
(2)

2
2

U
x
Substituting equation (2) into equation (1) and dividing yields:
(7)

1
2
1 2
2
1
2
1
2
2
1

+
+
U
x
U
x
f
x
U
x
U
x
U
x
f
x
where the RHS of equation (7) is the social MRS
1,2
. The social MRS
1,2
takes
into account all effects of consumption activities (marginal benefits to consumer
as well as marginal external costs imposed on others as a result of consumption
activity).
The social MRS
1,2
must take into account that substituting one unit of good
1 for good 2 affects the production of good 2 by and therefore the

f
x
2
1
individuals utility level is changed by .

U
x
f
x
2
2
1
Efficient production for firm 1
Rewrite equations (3) and (4). Substitute from equation (5):
2 2

(3)

1 1 2
2
1
1

f
y
(4)

2 1
1
2
1

f
y
Substitute equation (4) into equation (3). Dividing the equations yields:
(8)

1
2
1
2
1
2
1
1
1
2
1
1
2
1
2
1
1
1
1

+

f
y
f
y
f
y
f
y
f
y
The RHS of equation (8) is the social MRT
2,1
. By using one additional unit
of good 2 as an input, firm 1 produces and consequently affects the

f
y
1
2
1
production of good 2 by .

f
y
f
y
2
1
1
1
2
1
Efficient production for firm 2
Rewrite equations (5) and (6):
(5)
2 2

(6)

1 2
2
1
2

f
y
Dividing equation (6) by equation (5) yields:
(9)

1
2
2
1
2

f
y
Note that firm 2's production activity does not generate an externality,
hence the RHS of equation (9), the social MRT
1,2
, equals the private MRT
1,2
.
Pareto Optimal Allocation

1
2
1
2
2
1
1
2
1
2
1
1
2
1
2
12 21 12
1
+

U
x
U
x
f
x f
y
f
y
f
y
relative
scarcity
prices
social MRS social MRT social MRT
, , ,
Key results
optimal organization of economy does not necessarily require total
elimination of externalities, even when they are negative consumption
and production good 1 affects production of good 2 negatively but
optimality does not require eliminating production of good 1
in general, zero pollution is not optimal
external costs (or direct effects of one agents actions upon others) must be
internalized in consumption and production decisions
Competitive Equilibrium
Consumers decision problem
max
,
( , ) ( , )
x x
U x x B p p p p px p x
1 2
1 2 1 1 2 2 1 2 1 1 2 2
s.t. + + +
where is the value of the consumers initial endowment and p p
1 1 2 2
+
are industrial profits ( , ) p p
1 2
max
,
( , ) ( )
x x
L U x x + B px p x
1 2
1 2 1 1 2 2

L
x
U
x
p
1 1
1
0

L
x
U
x
p
2 2
2
0
Eliminating 8 yields:
p
p
U
x
U
x
1
2
1
2

relative prices = private MRS

12 ,
Firm 1's decision problem
max
( )
y
p y p y y f y
2
1
1
1 1
1
2 2
1
1
1 1
2
1
+ s.t.
max
( )
y
p f y p y
2
1
1
1
1
2
1
2 2
1
+

1
2
1 1
1
2
1 2
0
y
p
f
y
p +
p
p
f
y
1
2
1
2
1

p
p f
y
1
2
1
2
1
1

Firm 2's decision problem

max
( , , )
y
p f y y x p y
1
2
2
2
2
1
2
1
1
1 1 1
2
+

2
1
2 2
2
1
2 1
0
y
p
f
y
p +
p
p
f
y
2
1
2
1
2

p
p
f
y
1
2
2
1
2

Competitive Equilibrium
A competitive equilibrium is a vector of prices (p
1
,p
2
) and an allocation
such that ( ) x x y y y y
1 2 1
1
2
1
2
2
1
2
, , , , ,
firms profits and consumers utility are maximized (firstorder
necessary and sufficient conditions are satisfied)
supply and demand is equalized in both markets
At a competitive equilibrium, selfinterest maximization leads each agent to
equate his/her private marginal rate of substitution or transformation to the price
ratio, resulting in the equalization of private rates:
p
p
U
x
U
x
f
y
f
y
relative
prices
privateMRS privateMRT privateMRT
1
2
1
2
1
2
1
2
1
2
12 21 12
1

, , ,
Comparing Competitive Equilibrium and Pareto Optimum
In contrast, a Pareto optimal allocation requires equalization of social
marginal rates of substitution and transformation to relative scarcity or shadow
prices.
divergence of private and social valuations
economic decisions too decentralized at competitive equilibrium
agents generating negative externality will produce/consume too much
prices of negative externalitygenerating production or consumption goods
are too low (since full social costs of economic activity not reflected in
market prices)
In general, CE with externalities not PO!
Decentralized Solutions
Optimal Taxation
Is there a tax structure that will sustain a competitive equilibrium as a
Pareto optimum? Can we find a set of taxes for polluters and victim damage or
compensation payments that will induce consumers and firms to choose Pareto
optimal levels of economic activities?
Define: t
c
garbage tax per unit of good 1 consumed
t
f
emission tax per unit of good 1 produced
J damage compensation per unit of good 2 produced
Assume taxes collected are redistributed to consumer as lumpsum transfer T.
Consumers decision problem
( )
max
,
( , ) ( , ) ( )
x x
L U x x p p T p p p t x p x
c
1 2
1 2 1 1 2 2 1 2 1 1 2 2
+ + + + +

L
x
U
x
p t
c
1 1
1
0 + ( )

L
x
U
x
p
2 2
2
0
Eliminating 8 yields:
p
p
U
x
U
x
t
p
c 1
2
1
2
2

Firm 1's decision problem

max ( ) ( )
y
p t f y p y
f
2
1
1
1
1
2
1
2 2
1
+

1
2
1 1
1
2
1 2
0
y
p t
f
y
p
f
+ ( )
p
p
f
y
t
f 1
2
1
2
1
+

p
p f
y
t
p
f
1
2
1
2
1
2
1
+

Firm 2's decision problem

Damage compensation rates depend on victims activity level. For example,
if exogenous shift in demand leads to an increase in output, damage caused by
firm 1 and consumers will necessarily increase and hence compensation payment
must increase.
max
( ) ( , , )
y
p f y y x p y
1
2
2
2
2
1
2
1
1
1 1 1
2
+ +

2
1
2 2
2
1
2 1
0
y
p
f
y
p + + ( )
p
p
f
y
2
1
2
1
2

p
p
f
y p
f
y
1
2
2
1
2
2
2
1
2

Competitive Equilibrium with Taxes and Compensation

p
p
U
x
U
x
t
p f
y
t
p p
f
y
t p
f
x
t p
f
y
c
f
c f
1
2
1
2
2
1
2
1
2 2
2
1
2
2
2
1
2
2
1
1
1
1
0
+ +

_
,

* * *
set of taxes and compensation payments which will sustain a
{ }
t t
c f
* * *
, ,
competitive equilibrium which is Pareto optimal
optimal taxes are standard Pigouvian taxes taxes are set equal to the value
of the marginal damage of economic activities evaluated at the Pareto
optimal level of these activities taxes are based on a polluters pay
principle
Pigouvian taxes are asymmetric no subsidization or compensation of
victims necessary to sustain Pareto optimum provided t
c
and t
f
set optimally
market prices are now equal to shadow prices in social planners problem
Creation of markets by specifying property rights
Social planner wishes to establish a complete set of competitive markets
which incorporates externalities must assign property rights.
Suppose that social planner assigns firm 2 the right to an unpolluted river.
The initial assignment of property rights creates two pollution rights markets:
Consumer must purchase the right to pollute from firm 2:
price of right for consumer to pollute one unit p
1
12
Firm 1 must also purchase the right to pollute from firm 2:
price of right for firm 1 to pollute one unit q
1
12
Consumers decision problem
max
,
( , ) ( , )
x x
U x x p p p p px p x p x
x x
1 2
1 2 1 1 2 2 1 2 1 1 1
12
1
12
2 2
1
12
1
s.t. + + + +

where , the quantity of rights demanded by consumer, must equal x

1
, x
1
12
the number of units of pollution created.
( )
max
,
( , ) ( )
x x
L U x x B p p x p x
1 2
1 2 1 1
12
1 2 2
+ +

L
x
U
x
p p
1 1
1 1
12
0 + ( )

L
x
U
x
p
2 2
2
0
Eliminating 8 yields:
p
p
U
x
U
x
p
p
1
2
1
2
1
12
2

Firm 1's decision problem

max ( )
y
p y p y q y y f y
y y
2
1
1
1 1
1
2 2
1
1
12
1
12
1
1 1
2
1
1
12
1
1
+

s.t.
where is the quantity of pollution rights demanded by firm 1 and is y
1
12
y
1
1
firm 1's level of pollution. Note that, institutionally, firm 1 is constrained to
purchase as many rights as it creates units of pollution.
max
( ) ( )
y
p q f y p y
2
1
1
1 1
12 1
2
1
2 2
1
+

1
2
1 1 1
12
1
2
1 2
0
y
p q
f
y
p + ( )
p
p
f
y
q
1
2
1
2
1
1
12
+

p
p f
y
q
p
1
2
1
2
1
1
12
2
1
+

Firm 2's decision problem

Firm 2 will supply quantities of pollution rights at prices , $ , $ y x
1
12
1
12
q p
1
12
1
12
,
respectively.
max
, $ $
$ $ ( , $ , $ )
y y x
p y p y q y p x y f y y x
1
2
1
12
1
12
2
2 2
2
1 1
2
1
12
1
12
1
12
1
12
2
2 2
1
2
1
12
1
12
+ + + s.t.
max
, $ $
( , $ , $ ) $ $
y y x
p f y y x p y q y p x
1
2
1
12
1
12
2
2
2
1
2
1
12
1
12
1 1
2
1
12
1
12
1
12
1
12
+ + +

2
1
2 2
2
1
2 1 1 2
2
1
2
1
2
2
1
2
0
y
p
f
y
p p p
f
y
p
p
f
y
+

2
1
12 2
2
1
12 1
12
1
12
2
2
1
12
1
12
2
2
1
12
0
$ $ $ $ y
p
f
y
q q p
f
y
q
p
f
y
+

2
1
12 2
2
1
12 1
12
1
12
2
2
1
12
1
12
2
2
1
12
0
$ $ $ $ x
p
f
x
p p p
f
x
p
p
f
x
+
Note that firm 2 will sell the right to pollute so as to equate the market
value of the property right (MB of selling the right) to the value of the damage
created by selling the right (MC of selling the right).
Competitive equilibrium with marketable pollution permits
p
p
U
x
U
x
p
p f
y
q
p
f
y
1
2
1
2
1
12
2
1
2
1
1
12
2
2
1
2
1
+

Definition of competitive equilibrium requires marketclearing in both

pollution permit markets:
$
$
x x x
y y y
1
12
1
12
1
1
12
1
12
1
1


From firm 2's profitmaximization problem and marketclearing conditions
we have that
p p
f
x
p
f
x
t
q p
f
y
p
f
y
t
c
f
1
12
2
2
1
12 2
2
1
12
1
12
2
2
1
12 2
2
1
12
=
=
permit
prices
=
marginal damage
at Pareto optimum
Pigouvian
taxes

$
$
*
*
Substituting marketclearing permit prices into competitive equilibrium
conditions will yield conditions for Pareto optimal allocation.
by defining property rights, social planner can create missing markets
can sustain a competitive equilibrium as Pareto optimum with a complete
set of markets!
Marketable Permits versus Taxes
two decentralized solutions to externality problem
price set by central authority in tax regime
price determined by market forces in marketable permit system
economic agents find optimal price of pollution in decentralized,
atomistic economy invisible hand works provided there is a
complete set of markets
both solutions force economic agents to fully internalize costs of actions
solutions have identical allocative consequences but different distributional
consequences
Caveats
models assume externalities the only source of institutional failure
other possible sources of institutional failure
market failure
transaction costs administrative costs may differ
strategic behaviour
trading restrictions
regulatory failure
other distortionary policies may be in place such as
subsidization of externalitygenerating activity
incomplete information regulator must know MB and MD
curves exactly to set policies efficiently
incomplete enforcement models assumes full compliance
highly unlikely regulator has the resources and knowledge to
design perfect expost governance structure
regulatory capture
global failure