Pecuniary externality

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A pecuniary externality occurs when the actions of an economic agent cause an increase or decrease in market prices. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to buy a house. The externality operates through prices rather than through real resource effects.

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This is in contrast with technological or real externalities that have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment. As with real externalities, pecuniary externalities can be either positive (favorable, as when consumers face a lower price) or negative (unfavorable, as when they face a higher price).

The distinction between pecuniary and technological externalities was originally introduced by Jacob Viner, who did not use the term externalities explicitly but distinguished between economies (positive externalities) and diseconomies (negative externalities). [1]

Under complete markets, pecuniary externalities offset each other. For example, if someone buys whiskey and this raises the price of whiskey, the other consumers of whiskey will be worse off and the producers of whiskey will be better off. However, the loss to consumers is precisely offset by the gain to producers; therefore the resulting equilibrium is still Pareto efficient. [2] As a result, some economists have suggested that pecuniary externalities are not really externalities and should not be called such.

However, when markets are incomplete or constrained, then pecuniary externalities are relevant for Pareto efficiency. [3] The reason is that under incomplete markets, the relative marginal utilities of agents are not equated. Therefore, the welfare effects of a price movement on consumers and producers do not generally offset each other.

This inefficiency is particularly relevant in financial economics. When some agents are subject to financial constraints, then changes in their net worth or collateral that result from pecuniary externalities may have first order welfare implications. The free market equilibrium in such an environment is generally not considered Pareto efficient. This is an important welfare-theoretic justification for macroprudential regulation that may require the introduction of targeted policy tools. [4] [5] [6]

Roland McKean was the first to distinguish technological and pecuniary effects. [7]

Positive and Negative Pecuniary Externalities

Pecuniary externalities differ from traditional externalities in their influence on the allocation of resources within markets and do not necessarily lead to inefficiencies in resource allocation in the same way as traditional externalities do. [8] Instead, they mainly affect the distribution of wealth among market participants. Pecuniary externalities can be used to generate beneficial outcomes, however, since pecuniary externalities are Pareto efficient, they can also result in monopolies and other economic distortions.

Positive pecuniary externalities occur when changes in market prices result in beneficial outcomes for participants. Pecuniary externalities can be manipulated in order to redistribute wealth in a favorable way without resulting in a market failure. [9] For instance, pecuniary externalities can motivate individuals or firms to adopt technologies or practices that have spillover benefits for others. [10] Subsidies or tax incentives for renewable energy appliances, such as solar panels, can boost the household demand for these appliances. The decrease in electricity costs for others due to increased use of solar panels creates positive pecuniary externalities, making it beneficial for both individual adopters and society as a whole.

Negative pecuniary externalities occur when market price adjustments result in negative consequences for participants. For example, price increases caused by market dominance or monopolistic tendencies can result in a consumer surplus and disrupt the allocation of resources. [11] Despite the potential for positive outcomes, negative pecuniary externalities can cause distortions and inefficiencies by forcing firms to exercise undue influence over markets.

Related Research Articles

In welfare economics, a Pareto improvement formalizes the idea of an outcome being "better in every possible way". A change is called a Pareto improvement if it leaves everyone in a society better-off. A situation is called Pareto efficient or Pareto optimal if all possible Pareto improvements have already been made; in other words, there are no longer any ways left to make one person better-off, unless we are willing to make some other person worse-off.

In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium. General equilibrium theory contrasts with the theory of partial equilibrium, which analyzes a specific part of an economy while its other factors are held constant. In general equilibrium, constant influences are considered to be noneconomic, or in other words, considered to be beyond the scope of economic analysis. The noneconomic influences may change given changes in the economic factors however, and therefore the prediction accuracy of an equilibrium model may depend on the independence of the economic factors from noneconomic ones.

<span class="mw-page-title-main">Externality</span> In economics, an imposed cost or benefit

In economics, an externality or external cost is an indirect cost or benefit to an uninvolved third party that arises as an effect of another party's activity. Externalities can be considered as unpriced components that are involved in either consumer or producer market transactions. Air pollution from motor vehicles is one example. The cost of air pollution to society is not paid by either the producers or users of motorized transport to the rest of society. Water pollution from mills and factories is another example. All (water) consumers are made worse off by pollution but are not compensated by the market for this damage. A positive externality is when an individual's consumption in a market increases the well-being of others, but the individual does not charge the third party for the benefit. The third party is essentially getting a free product. An example of this might be the apartment above a bakery receiving some free heat in winter. The people who live in the apartment do not compensate the bakery for this benefit.

<span class="mw-page-title-main">Market failure</span> Concept in public goods economics

In neoclassical economics, market failure is a situation in which the allocation of goods and services by a free market is not Pareto efficient, often leading to a net loss of economic value. The first known use of the term by economists was in 1958, but the concept has been traced back to the Victorian philosopher Henry Sidgwick. Market failures are often associated with public goods, time-inconsistent preferences, information asymmetries, non-competitive markets, principal–agent problems, or externalities.

In microeconomics, economic efficiency, depending on the context, is usually one of the following two related concepts:

A Pigouvian tax is a tax on any market activity that generates negative externalities. A Pigouvian tax is a method that tries to internalize negative externalities to achieve the Nash equilibrium and optimal Pareto efficiency. The tax is normally set by the government to correct an undesirable or inefficient market outcome and does so by being set equal to the external marginal cost of the negative externalities. In the presence of negative externalities, social cost includes private cost and external cost caused by negative externalities. This means the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. Often-cited examples of negative externalities are environmental pollution and increased public healthcare costs associated with tobacco and sugary drink consumption.

Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and the costs imposed on the consumers as a consequence of being exposed to the transaction for which they are not compensated or charged. In other words, it is the sum of private and external costs. This might be applied to any number of economic problems: for example, social cost of carbon has been explored to better understand the costs of carbon emissions for proposed economic solutions such as a carbon tax.

Welfare economics is a field of economics that applies microeconomic techniques to evaluate the overall well-being (welfare) of a society. This evaluation is typically done at the economy-wide level, and attempts to assess the distribution of resources and opportunities among members of society.

Allocative efficiency is a state of the economy in which production is aligned with the preferences of consumers and producers; in particular, the set of outputs is chosen so as to maximize the social welfare of society. This is achieved if every produced good or service has a marginal benefit equal to the marginal cost of production.

<span class="mw-page-title-main">Edgeworth box</span> Model of an economic market

In economics, an Edgeworth box, sometimes referred to as an Edgeworth-Bowley box, is a graphical representation of a market with just two commodities, X and Y, and two consumers. The dimensions of the box are the total quantities Ωx and Ωy of the two goods.

In welfare economics, a social planner is a hypothetical decision-maker who attempts to maximize some notion of social welfare. The planner is a fictional entity who chooses allocations for every agent in the economy—for example, levels of consumption and leisure—that maximize a social welfare function subject to certain constraints. This so-called planner's problem is a mathematical constrained optimization problem. Solving the planner's problem for all possible Pareto weights yields all Pareto efficient allocations.

There are two fundamental theorems of welfare economics. The first states that in economic equilibrium, a set of complete markets, with complete information, and in perfect competition, will be Pareto optimal. The requirements for perfect competition are these:

  1. There are no externalities and each actor has perfect information.
  2. Firms and consumers take prices as given.
<span class="mw-page-title-main">Technology shock</span>

Technology shocks are sudden changes in technology that significantly affect economic, social, political or other outcomes. In economics, the term technology shock usually refers to events in a macroeconomic model, that change the production function. Usually this is modeled with an aggregate production function that has a scaling factor.

The Lange model is a neoclassical economic model for a hypothetical socialist economy based on public ownership of the means of production and a trial-and-error approach to determining output targets and achieving economic equilibrium and Pareto efficiency. In this model, the state owns non-labor factors of production, and markets allocate final goods and consumer goods. The Lange model states that if all production is performed by a public body such as the state, and there is a functioning price mechanism, this economy will be Pareto-efficient, like a hypothetical market economy under perfect competition. Unlike models of capitalism, the Lange model is based on direct allocation, by directing enterprise managers to set price equal to marginal cost in order to achieve Pareto efficiency. By contrast, in a capitalist economy, private owners seek to maximize profits, while competitive pressures are relied on to indirectly lower the price, this discourages production with high marginal cost and encourages economies of scale.

<span class="mw-page-title-main">Peter Diamond</span> American economist (born 1940)

Peter Arthur Diamond is an American economist known for his analysis of U.S. Social Security policy and his work as an advisor to the Advisory Council on Social Security in the late 1980s and 1990s. He was awarded the Nobel Memorial Prize in Economic Sciences in 2010, along with Dale T. Mortensen and Christopher A. Pissarides. He is an Institute Professor at the Massachusetts Institute of Technology. On June 6, 2011, he withdrew his nomination to serve on the Federal Reserve's board of governors, citing intractable Republican opposition for 14 months.

In neoclassical economics, a market distortion is any event in which a market reaches a market clearing price for an item that is substantially different from the price that a market would achieve while operating under conditions of perfect competition and state enforcement of legal contracts and the ownership of private property. A distortion is "any departure from the ideal of perfect competition that therefore interferes with economic agents maximizing social welfare when they maximize their own". A proportional wage-income tax, for instance, is distortionary, whereas a lump-sum tax is not. In a competitive equilibrium, a proportional wage income tax discourages work.

In financial economics, a liquidity crisis is an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

Macroprudential regulation is the approach to financial regulation that aims to mitigate risk to the financial system as a whole. In the aftermath of the late-2000s financial crisis, there is a growing consensus among policymakers and economic researchers about the need to re-orient the regulatory framework towards a macroprudential perspective.

Prudential capital controls are typical ways of prudential regulation that takes the form of capital controls and regulates a country's capital account inflows. Prudential capital controls aim to mitigate systemic risk, reduce business cycle volatility, increase macroeconomic stability, and enhance social welfare.

This glossary of economics is a list of definitions of terms and concepts used in economics, its sub-disciplines, and related fields.

References

  1. Jacob Viner (1932) "Cost Curves and Supply Curves", Journal of Economics, vol. 3, pp. 23-46.
  2. Jean-Jacques Laffont (2008). "Externalities," The New Palgrave Dictionary of Economics , 2nd Edition. Abstract.
  3. Bruce Greenwald; Joseph Stiglitz (May 1986). "Externalities in economies with imperfect information and incomplete markets" (PDF). Quarterly Journal of Economics . 101 (2): 229–264. doi: 10.2307/1891114 . JSTOR   1891114.
  4. Javier Bianchi; Enrique G. Mendoza (June 2010). "Overborrowing, Financial Crises and 'Macro-prudential' Taxes" (PDF). NBER Working Paper No. 16091. doi: 10.3386/w16091 .
  5. Enrico Perotti; Javier Suarez (December 2011). "A Pigouvian Approach to Liquidity Regulation". International Journal of Central Banking.
  6. Olivier Jeanne; Anton Korinek (September 2010). "Managing Credit Booms and Busts: A Pigouvian Taxation Approach" (PDF). NBER Working Paper No. 16377. doi: 10.3386/w16377 .
  7. McKean, Roland N. (1958). Efficiency in Government through Systems Analysis. A RAND Corporation Research Study. New York: John Wiley and Sons, Inc. p. 386. ISSN   0079-7723.
  8. Worcester, Dean A. (1969). "Pecuniary and Technological Externality, Factor Rents, and Social Costs". The American Economic Review. 59 (5): 873–885. ISSN   0002-8282. JSTOR   1810682.
  9. "Pecuniary Externalities in Competitive Economies with Limited Pledgeability | Richmond Fed". www.richmondfed.org. Retrieved 2024-04-28.
  10. "Pecuniary Externalities, Segregated Exchanges, and Market Liquidity in a Diamond-Dybvig Economy with Retrade | Richmond Fed". www.richmondfed.org. Retrieved 2024-04-28.
  11. Dávila, E., & Korinek, A. (2017). Pecuniary externalities in economies with financial frictions.The Review of Economic Studies, 85(1), 352–395. https://doi.org/10.1093/restud/rdx010