Public Finance, 2nd Edition

Production externality: Economic activity by some Wrm enters (alters) the

production function of at least one other Wrm but does not enter (alter) the

utility function of any consumer. One Wrm removing oil from a common pool

situated under land owned by more than one Wrm would be an example. The

rate at which any one Wrm extracts the oil aVects the total amount of oil that

can be extracted from the pool by all the Wrms.

Consumption±production externality: Economic activity by some con-

sumer enters (alters) the production function of at least one Wrm, or vice

versa. Water pollution by a Wrm that aVects both recreational and com-

mercial Wshing activities is an example of a consumption±production exter-

nality.

These distinctions are useful analytically because they generate diVerent

optimal policy rules. Chapters 6, 7, and 8 consider each of them in turn,

beginning with consumption externalities in Chapter 6.

Still other terminological distinctions appear in the externality literature.

We will develop them as needed within each chapter, whenever they are

relevant for public policy.

2

THE ANALYSIS OF EXTERNALITIES: MODELING PRELIMINARIES

Chapter 3 described a useful property of Wrst-best general equilibrium

models, that their Wrst-order conditions dichotomize in two ways. One is

that they generate distinct sets of interpersonal equity and pareto-optimal

conditions. The former incorporate the social welfare function and describe

how society can achieve end-results equity through lump-sum redistribu-

tions. The latter describe all the eYciency conditions necessary for society

to achieve its utility-possibilities frontier. The pareto-optimal conditions do

not contain any social welfare terms and can be achieved by competitive

markets absent any of the technical market failures such as externalities. The

dichotomization of the interpersonal equity and pareto-optimal conditions

was demonstrated in Chapter 2. The second dichotomy arises within the set

of pareto-optimal conditions. Suppose that a technical market failure such as

2

The treatment of externalities in Chapters 6±8 is comprehensive, with one notable excep-

tion. It does not consider an important type of externality called the club good, which was Wrst

analyzed by James Buchanan. A club good has the property that the extent of the externality can

be controlled by the agents who generate the externality. For example, all members of a swim

club have equal access to the club's swimming pool, but the club members control the total

membership in the club. Buchanan's club good has appeared most prominently in the literature

on Wscal federalism because a city or town can be viewed as a type of club. The standard economic

model of a local jurisdiction assumes that only the citizens of a locality enjoy the public services

oVered by that locality, such as Wre or police protection, and that the citizens determine the

conditions of entry into the locality. We will hold oV on presenting the club good until Part V on

Wscal federalism. See J. Buchanan, ``An Economic Theory of Clubs,'' Economica, February 1965.

148 THE ANALYSIS OF EXTERNALITIES: MODELING PRELIMINARIES