Public Finance, 2nd Edition

5

THE PROBLEM OF

EXTERNALITIESÐAN OVERVIEW

POLICY-RELEVANT EXTERNALITIES

The Terminology of Externalities

THE ANALYSIS OF EXTERNALITIES: MODELING PRELIMINARIES

The Interpersonal Equity Conditions

The Pareto-Optimal Conditions

We begin our study of public expenditure theory with an analysis of

externalities, which are a major source of ineYciency in any economy, market

or otherwise. Externalities are often loosely deWned as third-party eVects,

meaning that some activity by a set of economic agents aVects other economic

agents, ``third parties,'' who are not directly engaged in the activity. This

common deWnition is not precise enough for policy analysis, however. Be-

cause an economy is a highly interdependent system, almost any (important)

economic activity generates repercussionsÐthird party eVectsÐthroughout

the entire economy. Yet, not all economic activity requires public sector

intervention.

POLICY-RELEVANT EXTERNALITIES

Consider the following two examples of externalities:

1. In the middle of the twentieth century, the demand for long-distance

passenger travel shifted toward the airplane at the expense of the

railroads.

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2. A family living on the top of a hill builds a high fence around its

property, which restricts the view previously enjoyed by many of its

neighbors.

The Wrst situation triggered a huge number of third-party eVects as the

economy worked to accommodate the shift in demand. Generally speaking,

resources speciWc to air travel gained, and those speciWc to rail travel lost,

signaling a shift of resources away from the railroads and toward the airlines.

Since people's tastes presumably diVer, and diVerent people received diVerent

incomes than before the shift to air travel, the whole pattern of demands for

all goods and services tended to shift as well. These changes in demand

occasioned still further changes in incomes and additional resource shifts to

and from industries that may have been totally unrelated to air or rail travel,

and so on, endlessly. Yet, the government did not necessarily have to inter-

vene in this process. To the contrary, the very strength of the competitive

market system is its ability to coordinate shifts in demands and resources,

while bringing the economy to a new, eYcient equilibrium.

In the second situation, however, the third-party eVects occur outside the

normal market process. There is no natural market mechanism for recording

the loss that each neighbor suVers from the fence. Any redress the neighbors

might seek would presumably occur through the judicial process.

There is a second crucial diVerence in these two examples. In the Wrst

situation, the demand shifts in and of themselves have no eVect on any of the

fundamental technical relationships in the economy: the consumers' utility

functions and the producers' production functions. All third-party gains and

losses accrue through changes in prices, both goods prices and factor prices.

Some consumers faced new budget constraints and some Wrms new proWt

functions, with corresponding gains or losses, all caused by the competitive

process of supply and demand which continuously changes consumer and

producer prices while searching for a new equilibrium. In the second situ-

ation, in contrast, the neighbors lose because the properties of one of the

variables in their utility functions, their land, has been altered and not

because prices have changed. Each neighbor's ability to enjoy his own prop-

erty has diminished because of the fence, independently of any price changes

generated by building the fence (of course, it is unlikely that prices would

change in this case).

These two distinctions are the vital ones for public sector analysis. An

externality, or third-party eVect, may require government intervention to

maintain eYciency if two conditions hold:

1. An activity by a set of economic agents enters (``alters'') the utility

functions of other consumers or the production functions of other producers

not directly involved with the activity.

2. The gains and losses from these eVects are not properly reXected in the

competitive market system. This second condition is redundant in most cases,

146 POLICY-RELEVANT EXTERNALITIES