ECONOMIC THEORY OF EXTERNALITIES

Economic efficiency is defined as occurring when it is not possible to make someone better off without making others worse off, which occurs when the marginal social benefit of consumption equals the marginal social cost of production. In theory, with a specific definition of ‘‘perfect competition,’’ markets achieve economic efficiency. Some of the assump­tions are the absence of market power, markets that provide costless and accurate information, rational behavior narrowly defined, the absence of public goods (or public bads), and the absence of external­ities. Externalities occur whenever decisions of economic agents cause incidental costs or benefits borne by others that are not reflected in market prices. In particular, external costs drive a wedge between social and private marginal benefits and costs (Fig. 1).

Price

ECONOMIC THEORY OF EXTERNALITIES

FIGURE 1 Marginal social benefit and cost.

If accurate information were costless, markets would be unnecessary. Markets provide imperfect information at a cost. All markets, whether for pollution credits, future prices of wholesale natural gas or electricity, or commodities sold to consumers, require government regulation to establish and enforce property rights. Property rights specify the right to pollute or, conversely, the right to a clean environment. Both markets and government enforce­ment of property rights that regulate markets are costly. Broadly, the idea of economic efficiency can inclusively consider the costs of markets and their regulation, including the costs of providing public goods and regulating externalities. In this sense, economic efficiency is the criterion most economists favor to evaluate policy changes. Although there is reason to be sympathetic toward the criterion of economic efficiency, the fundamental assumptions of economic efficiency are inconsistent with most applications to energy externalities. Finally, the criterion of economic efficiency is not adequate to assess strategies to reduce macroeconomic risks or technology forcing policies designed to alter the course of technological change.

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