| The aim of this research is a systematic study of one of the important reasons for market failure, namely, the existence of externalities and the design of policies to combat them. Two alternative general equilibrium models are developed that capture certain peculiarities that have been associated with externalities. These peculiarities include: (i) the fundamental non-convexities of feasible sets of economic agents subject to detrimental externalities, (ii) the public good property possessed by several externalities, and (iii) the fact that externalities are by-products, as opposed to joint products, of the deliberate actions of economic agents. The two models, together, explain the prevalence of alternative government policies in the real world to tackle the problem of externalities: (i) policies that control external effects in an economy by directly controlling the externalities (e.g., a Pigouvian tax on emissions of smoke by firms) and (ii) policies that control the external effects by controlling the levels of commodities responsible for causing the externalities (e.g., a Pigouvian tax on the usage of coal as an input by firms). It is shown that the two models and, hence, the two sets of government policies are Pareto equivalent. To characterize the Pareto optimal allocations, tools have been borrowed from the rich literature, motivated primarily by the existence of increasing returns and natural monopolies, that now exists on non-convex economies. However, since the non-convexities associated with externalities have a different motivation, the results from the literature on nonconvex analyses have been adapted to this context. This research also recognizes the fact that, often in the real world, (i) policies have to be more incremental moving economies in the right directions rather than involve a quantum leap from status-quo to the best allocation and (ii) the problem of externalities is often accompanied with other sources of market failure making it possible to consider only second-best as opposed to first-best policies. Thus, we also study the design of Pareto-improving and equilibrium-preserving directions of change (reforms) in the government's policy instruments in a second-best world, where, apart from externalities, there also exist distortional commodity taxes, the motivation for which is the inability of the government to implement personalized lump-sum transfers. We find that, contrary to the case of an economy where an externality is the only distortion, starting at an initial status-quo of a second-best world with externalties, it might be Pareto-improving and equilibrium-preserving for the regulator to mandate an increase in the level of a negative externality. |
