Externalities — A market model failure

We focus here on a set of conceptual problems related to the accepted theory of externalities. We are primarily concerned with difficulties that arise when a theoretical system is extended beyond its logical domain. This is the practice in externality theory when the market model assuming independent agents is used to analyze physical interdependency. The different kinds of dependencies obscure the standard use of the Paretian analysis, as the issues of rights and efficiency are mixed up. The creation of emissions and the creation of externalities are further not held apart producing flows in the efficiency evaluations. Due to the interdependencies involved, actions of both emitter and victim must be taken into account while searching for efficient policies. Finally, we analyze the interrelationships between what is termed the internal structure of the market model and the annexed sphere of externalities. We conclude that the accepted policy prescriptions both assume and demand no interrelationships between these two spheres. We find the assumption unrealistic and inconsistent as concerns the basic foundations of the market model. There are two main traditions addressing externalities — the Coasean and the Pigovian. This paper shows that both are vulnerable to the above critique. Thus the presumption that externality theory is now settled and coherent is seen to be without theoretical support. Copyright Kluwer Academic Publishers 1997