Economics of Externalities: An Overview

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.