Public Finance, 2nd Edition

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PRODUCTION EXTERNALITIES

THE CONDENSED MODEL FOR PRODUCTION EXTERNALITIES

AGGREGATE PRODUCTION EXTERNALITIES

The First-Order ConditionsÐPareto Optimality

The Pigovian Tax

Three Geometric Interpretations of the Pareto-Optimality Conditions

Internalizing the Externality

Additional Policy Considerations

CONCLUDING COMMENTS: THE PROBLEM OF NONCONVEX

PRODUCTION POSSIBILITIES

A policy-relevant, technological production externality has two proper-

ties: Production activity by some Wrm directly enters into (or ``alters'') the

production function of at least one other Wrm, and the external eVect is not

captured in the marketplace. These properties are completely analogous to

those of a policy-relevant, technological consumption externality. Therefore,

having analyzed various consumption externality models in some detail, the

treatment of production externalities can be fairly brief. The production

models and the resulting pareto-optimal decision rules for production exter-

nalities are virtually identical to their consumption counterparts, with the

roles of consumption and production reversed. In particular, there are these

important similarities:

1. The pareto-optimal decision rules for consumption externalities re-

quire equating marginal rates of transformation in production to summa-

tions of marginal rates of substitution in consumption. For production

externalities, summations of marginal rates of transformation in production

(or the marginal rates of technical substitution equal marginal rates of

substitution in consumption.

2. In both instances, the government can achieve pareto optimality by

retaining decentralized markets and taxing (subsidizing) an externality-

generating exclusive activity.

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