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Edited by Jeroen C.J.M. van den Bergh
Chapter 13: Externalities
Erik T Verhoef * 1. Introduction External effects have been studied by economists ever since the days of Marshal1 and Pigou. Along with the development of the field of environmental economics, the theory of externalities has remained of great and growing importance in economic science. Indeed, it is fair to say that, starting from the traditional neoclassical economic framework, the most logical way to look at problems of environmental pollution is from the perspective of external costs (see, for instance, Baumol and Oates, 1988; Pearce and Turner, 1990; Cropper and Oates, 1992; Tietenberg, 1994). However, although economists have been investigating the concept of externalities for a long time, both theoretically and empirically, externalities still prove to be an area of slippery ice. Frequently one finds fuzzy discussions on the policy implications of external costs. This may often result from, for instance, mixing up equity and allocative efficiency arguments, from mistaking pecuniary externalities for ‘true’ or technological externalities, or from some sense of compassion with the victims of externalities on equity grounds, leading to pleas for ‘compensation’which may often be unwarranted from the perspective of allocative efficiency. This chapter aims at shedding some light on the concept of ‘externalities’. It starts with a brief discussion of market failures in the neoclassical economic framework. It then proceeds to a definition of externalities, thereby distinguishing external effects from other sorts of ‘unpriced effects’. Finally, some attention is paid to the relation, and tension, between efficiency and equity impacts of externalities. The discussion in this...
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