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Trade Theory, Analytical Models and Development

Essays in Honour of Peter Lloyd, Volume I

Edited by Sisira Jayasuriya

Trade Theory, Analytical Models and Development, comprises 11 essays offering new contributions on the following topics: trade and wages; factor endowments, factor mobility and political economy of trade; optimality of tariffs; measurement of welfare; customs union theory; endogenous mergers and tariffs; intra-industry trade; state trading enterprises and trade liberalisation; general equilibrium effects of e-Commerce, and trade; economic growth with production and consumption externalities; and environmental pollution and resource degradation.
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Chapter 9: Consumption and production externalities in a small open economy with accumulating capital

Stephen J. Turnovsky and Wen Fang Liu


* Stephen J. Turnovsky and Wen Fang Liu 1. INTRODUCTION The role of distortions in international economies was an early interest of Peter Lloyd during the period that he and one of the present authors (Stephen Turnovsky) were colleagues at the Australian National University. Distortions may manifest themselves in diverse ways and Peter’s research focused on the role of taxes and subsidies; see Lloyd (1973, 1974). Recently there has been a surge of interest in the effects of distortions arising through the presence of externalities. At issue here is the failure of agents to recognize their individual contributions to the collective economic environment, which in turn influences their own behaviour. Indeed, externalities are an integral aspect of a modern interdependent economy. The fact that households interact with one another makes it inevitable that their choices will influence one another directly, in addition to any impact that may occur through the marketplace. Economists are, of course, well aware of this phenomenon and the role of externalities has been widely studied in a variety of contexts. Externalities can be usefully categorized as being consumption externalities, on the one hand, and production externalities, on the other. Consumption externalities have been extensively studied in the context of models of ‘jealousy’ and ‘keeping up with the Joneses’. For example, Abel (1990) and Gali (1994) studied the effects of consumption externalities on asset pricing and the equity premium, while Ljungqvist and Uhlig (2000) analysed the impact of consumption externalities on the effect...

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