In this chapter, we construct a model of externalities that can then be used to derive formally the results discussed in the preceding chapter. This model and the associated analysis will serve as the basis for much of the treatment in later chapters.

Throughout the book we will utilize general equilibrium models almost exclusively. In welfare economics, perhaps as much as in any branch of our subject, there is real danger in partial analysis. When we consider expanding one sector of the economy, say, because of the net social benefits that it generates, it is essential that we take into account where the necessary resources will come from and what the consequences in other sectors will be. Interdependence among location decisions, levels of polluting outputs, and the use of pollution-suppressing devices are all at the heart of the problem. Indeed, the very concept of externalities implies a degree of interdependence sufficient to cast doubt upon the reliability of the partial analysis that, curiously, has often characterized writings in this area.

Pareto optimality in the basic externalities model

In this section, we first describe the structure of the basic model and then derive the necessary conditions for Pareto optimality. With this done, we can determine fairly easily in the two subsequent sections what prices and taxes are necessary to induce firms and individuals to behave in a manner compatible with the requirements for Pareto optimality.