Table Of ContentECONOMIC THEORY AND MATHEMATICAL ECONOMICS
Consulting Editor: Karl Shell
UNIVERSITY OF PENNSYLVANIA
PHILADELPHIA, PENNSYLVANIA
Franklin M. Fisher and Karl Shell. The Economic Theory of Price Indices:
Two Essays on the Effects of Taste, Quality, and Technological Change
Luis Eugenio Di Marco (Ed.). International Economics and Development:
Essays in Honor of Raul Presbisch
Erwin Klein. Mathematical Methods in Theoretical Economics: Topological
and Vector Space Foundations of Equilibrium Analysis
Paul Zarembka (Ed.). Frontiers in Econometrics
George Horwich and Paul A. Samuebon (Eds.). Trade, Stability, and Macro-
economics: Essays in Honor of Lloyd A. Metzler
W. T. Ziemba and R. G. Vickson (Eds.). Stochastic Optimization Models in
Finance
Steven A. Y. Lin (Ed.). Theory and Measurement of Economic Externalities
In preparation
C. W. J. Granger and Paul Newbold. Forecasting Economic Time Series
Theory and Measurement
of
Economic Externalities
EDITED BY
Steven A. Y. Lin
Department of Economics
Southern Illinois University
Edwardsville, Illinois
ACADEMIC PRESS New York San Francisco London
A Subsidiary of Harcourt Brace Jovanovich, Publishers
COPYRIGHT © 1976, BY ACADEMIC PRESS, INC.
ALL RIGHTS RESERVED.
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Libraiy of Congress Cataloging in Publication Data
Main entry under title:
Theory and measurement of economic externalities.
(Economic theory and mathematical economics)
"This volume is the direct result of a conference
on externalities held at Southern Illinois Univer-
sity at Edwardsville, April 19-20, 1974."
Includes bibliographies and index.
1. Externalities (Economics)-Congresses.
I. Lin, Steven A. Y., Date II. Southern
Illinois University, Edwardsville.
HB199.T48 1976 33θ'.01 75-32030
ISBN 0-12-450450-7
PRINTED IN THE UNITED STATES OF AMERICA
List of Contributors
Numbers in parentheses indicate the pages on which the authors' contributions begin.
Gerald E. Auten (37), Department of Economics, University of Missouri, Columbia,
Missouri
Theodore C. Bergstrom (111), Department of Economics, The University of Michigan, Ann
Arbor, Michigan
David F. Bradford (201), Department of Economics, Princeton University, Princeton, New
Jersey
Charles J. Cicchetti (183), Department of Economics and Environmental Studies, University
of Wisconsin, Madison, Wisconsin
Arthur S. De Vany (205), Department of Economics, Texas A & M University, College
Station, Texas
Theodore Groves (65), Graduate School of Management, Nathaniel Leverone Hall,
Northwestern University, Evanston, Illinois
Donald R. Haurin (217), Department of Economics, Ohio State University, Columbus, Ohio
David F. Heathfield (215), University of Southampton, England, and Department of
Economics, Washington University, St. Louis, Missouri
Walter P. Heller (9), Department of Economics, University of California at San Diego, La
Jolla, California
Arye Leo Hillman (103), Department of Economics, Tel-Aviv University, Ramat-Aviv,
Tel-Aviv, Israel
John O. Ledyard (23), Department of Economics, Northwestern University, Evanston,
Illinois
Steven A. Y. Lin (45), Department of Economics, Southern Illinois University, Edwards-
ville, Illinois
James T. Little (61,85), Department of Economics, Washington University, St. Louis,
Missouri
Edna T. Loehman (87), Department of Food and Resource Economics, University of
Florida, Gainesville, Florida
Hugh O. Nourse (243), Department of Economics, University of Missouri, St. Louis,
Missouri
J. Trout Rader, III (135), Department of Economics, Washington University, St. Louis,
Missouri
xi
xii List of Contributors
Robert W. Rosenthal (177), Department of Industrial Engineering and Management Science,
Northwestern University, Evanston, Illinois
Lloyd S. Shapley (155), The Rand Corporation, Santa Monica, California
V. Kerry Smith (183), Department of Economics, State University of New York,
Bingham ton, New York
Charles G. Stalon (259), Department of Economics, Southern Illinois University,
Carbondale, Illinois
David A. Starre« (9,133,153), Department of Economics, Stanford University, Palo Alto,
California
Ephraim F. Sudit (247), Trust Division, The Chase Manhattan Bank, New York, New York
George S. Tolley (217), Department of Economics, University of Chicago, Chicago, Illinois
Andrew B. Whinston (87), Graduate School of Industrial Administration, Purdue University,
West Lafayette, Indiana
David K. Whitcomb (45), Graduate School of Business Administration, Rutgers University,
New Brunswick, New Jersey, and Salomon Brothers Center for the Study of
Financial Institutions, New York University, New York
Richard O. Zerbe (29), Program in the Social Management of Technology and Department
of Economics, The University of Washington, Seattle, Washington, and Department of
Economics, Northwestern University, Evanston, Illinois
Preface
Externalities (or sometimes, "third-party effects" or "spillover effects") arise
whenever the value of a production function or a consumption function depends
directly upon the activity of others. Interest in this notion of externality as a
phenomenon in the context of partial equilibrium analysis has grown steadily
and picked up momentum in the postwar period; many economists will now
agree that externalities should be a new field of specialization within the broader
terrain of welfare economics.
Despite its popularity, the field of externalities remains one of the relatively
underdeveloped areas of economics, an exception to "the principles" of price
and welfare theory rather than a part of them. Clearly, it would be desirable to
integrate externalities into the core of modern economic theory, and this
volume is but one of the major efforts in this direction.
Basically, economists are serving the function of turning out consumers'
goods in the form of applications of existing knowledge to current problems,
and of turning out producers' goods in the form of better knowledge, analytical
formulations, and approaches for application to current problems. The latter
function is stressed in this book. The objective of the book is to provide
cross references and opportunity for give-and-take discussion on some recent
analytical and empirical developments in the field of externalities.
This volume is the direct result of a Conference on Externalities held at
Southern Illinois University at Edwardsville, April 19—20, 1974. Support for the
conference was provided by the University's School of Business.
A large number of people cooperated to make the conference and this book
possible. I would especially like to thank Professors Paul Sultan, William Vickrey,
Louis Drake, and Trout Rader for chairing the four sessions, and Professors Ted
Bergstrom and J. F. Schwier for their editorial advice. Dean Paul Sultan's
interest and encouragement is also greatly appreciated. In addition, I would like
to thank Ms. Mary Lelik for her excellent typing. My greatest debt is to all the
xiii
xiv Preface
conference participants, especially those contributing to this volume. Frankly, I
had not foreseen the depth of their cooperative spirit and patience. The
participants' experience, good judgement, and friendliness made it all possible.
I
Introduction
Generally, effects on persons not directly privy to the decision leading to an
activity are termed externalities or third-party effects (or sometimes "spillover
effects"). Externalities arise whenever the value of an objective function, for
example the profits of a firm or the happiness of an individual, depends upon
the unintended or incidental by-products of some activity of others
(Bergstrom [2, 3], Buchanan and Stubblebine [5], Cheung [6], Coase [7],
Demsetz [9, 10], Freeman et al. [12], Mishan[15], Starre« [19]). For
instance, when a paper mill produces pulp for newsprint, more people are
affected than its suppliers, employees, and customers. Its emissions into the air
may annoy people who live nearby and may make nearby resort areas less
attractive thus reducing tourist revenues which local motel operators and boat
renters can expect; its effluent discharged into the water may hurt the fishing,
and thus fishermen who ply the waters in the vicinity. All these are examples of
external diseconomies; but, of course, there are external economies as well.
The notion of externalities is especially interesting in connection with
analyses of economic welfare. When externalities exist, benefits or costs seen by
private individuals differ from the true social cost consequences of their actions.
Consequently, decentralized decision making and Lerner's "rule" may fail, in the
1
2 / Introduction
presence of externalities, to produce an optimal allocation of resources for the
society.
In Pigou's celebrated Economics of Welfare [17], externalities appear as one
of the chief causes of divergence between "private net product" and "social net
product." Pigou's welfare criterion is that the national dividend will be
maximized when the values of marginal social net products are equal in all uses.
That criterion is met if marginal social net products and marginal private net
products are the same because the values of marginal private net products are
equal in all uses and the values of marginal social net products are computed
without regard to whom they accrue.
Pigou recognized that marginal social and marginal private products may
diverge even under perfect competition. He mentioned two cases. In the first
case, there are uncompensated services or disservices to the general public arising
from the production of a good or service. In the second, a competitive industry
has an increasing or decreasing long-run supply price as industry output
increases. Pigou, of course, was also aware of the inconsistency between
increasing returns to a firm and competitive equilibrium.
When the "new welfare economics" appeared in the early 1940s utilizing
Pareto optimality (Pareto [16]) as the strongest welfare criterion, externalities
were also shown to lead in an otherwise perfectly competitive system to an
equilibrium that violated the conditions of Pareto optimality. Rigorous proof of
this is to be found in such standard price theory texts as Henderson and
Quandt [13].
What, if anything, can be done about the welfare effects of externalities?
Pigou believed that he could see a modified invisible hand: a system of taxes and
bounties. He was convinced that a determinate scheme of taxes and bounties
exists that would equate marginal social and private products and, hence, that
would induce profit maximizing firms which are generating externalities to move
to the ideal output level; that is, the one at which the national dividend is
maximized. However, he was unable to specify the means by which such taxes
and bounties could be computed.
Recently, a rather different school of thought has emerged. It is primarily
concerned with ways of achieving optimal allocation under externalities. The
prescriptions of this school contrast with centralized tax and bounty schemes,
and it may be classified under the general heading of decentralized approaches to
the externality problem. One wing of this school is the "private bargaining
approach" advanced by Coase [7] and endorsed by Buchanan [4]. Because, as
Coase pointed out, the socially optimal outputs are those that maximize the
combined profits of the firms affected by externalities, this approach holds that
the firms themselves have incentive to agree to produce the optimal outputs,
kinds and quantities of commodities, and then distribute the total profit such
that each firm's profit is greater than, or equal to, the profit that it could earn
/ Introduction 3
by maximizing profit individually without bargaining. Thus, state intervention
by means of taxes and subsidies is not always needed in order to achieve a social
optimum.
Relative legal rights are of more than incidental concern in considerations of
the achievement of an accommodation among the parties whose objective
functions are involved in an externality. Neither property nor personal rights are
always clear and negotiation often is difficult. Of course, the legal rights of the
affected parties may be defined or clarified by the legislature or by the courts,
thereby enabling the parties to negotiate a settlement of their own differences
and, presumably, a solution of the social optimization problem more readily.
Furthermore, a "merger" is often an alternative. For example, suppose the
occupants of a boarding house next door bother us with loud noises. We may
"merge" by buying the house next door, thus "internalizing" the externality
because the newly formed "organization" would take all costs into account. But
merger is not always an option. No single party owns a river, or, as a practical
matter, can acquire all the property rights by buying the land on both sides of a
river. Thus factories as well as fishermen and others may seek to use the river
and exercise the rights to its use; and the fishermen, and the others, may have
difficulties merging with the factories. In addition, the transaction costs of
bargaining can be very great and information about other peoples' preferences is
quite difficult to obtain, hence very costly. This would be the case when the
parties are so numerous that there is no way that they can sit down and talk
with one another — for example, a great number of people using contaminated
water from a certain river.
Coase has also brought to the analysis of externalities an emphasis on
opportunity costs which prevail in price theory. In addition to considering the
social product of the firms as the amount of the externality varies, he insists that
we must also take into account the social product that would be forthcoming if
some of the firms move into another line of business. In particular, in Pigou's
example of the damage done to crops by the sparks from a passing train, the
unavoidable damage will not be the total value of the crops destroyed — if the
farmer can grow crops elsewhere or switch to a strain of spark-resistant crops
(Coase [7],Mishan [15]).
Coase argued that once property rights were clearly defined it was in the
interests of the rancher and of the farmer whose crops were being damaged by
roaming cattle to negotiate a solution. It can be pointed out, of course, that such
would be true even if the property rights were not clearly defined. Indeed, the
less clear the relative rights, the better it may be for the farmer to negotiate an
agreement that settles the question.
However, even if property rights are well enough defined that an agreement
might be negotiated, motivation may remain for defections from the agreement
by the parties unless some clear responsibility for harm can be invoked to
