Pecuniary externality
Encyclopedia
A pecuniary externality is an externality
which operates through prices rather than through real resource effects. 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 get onto the property ladder
.
This is in contrast with technological or real externalities which have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment. Both pecuniary and real externalities can be either positive or negative.
Under complete market
s pecuniary externalities offset each other. For example, if I buy whiskey and this raises the price of whiskey, the 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.
As a result, some economists have suggested that pecuniary externalities aren't really externalities and shouldn't be called such.
However, when markets are incomplete or constrained, then pecuniary externalities are relevant for Pareto efficiency.
The reason is that under incomplete markets
, the relative marginal utilities of agents are not equated. Therefore a redistribution 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 constrained Pareto efficient, implying that there is a role for government intervention to mitigate or magnify pecuniary externalities. This is an important welfare-theoretic justification for macroprudential regulation.
For other recent publications on pecuniary externalities see 'Price, C. (2007) Sustainable forest management, pecuniary externalities and invisible stakeholders. Forest Policy and Economics 9: 751-762.' An early reference that makes use of this terminology is 'Prest, A. R. and R. Turvey (1965) Cost-Benefit Analysis: A Survey. The Economic Journal 75: 683-735. The notion of a 'pecuniary spillover' is also introduced by 'McKean, Roland (1958) Efficiency in Government through Systems Analysis: With Emphasis on Water Resources Development (John Wiley: New York).' McKean notes that economists often make a distinction between technological and pecuniary effects, which may have been true at the time but is not the case today.
Externality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
which operates through prices rather than through real resource effects. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices
House prices
House prices fluctuate over time. For more detailed articles referring to specific economies:- Affordability of housing in the United Kingdom: House prices in the UK- Real estate pricing: House prices in the United States...
, making it difficult for young people in the area to get onto the property ladder
Property ladder
The property ladder is a term widely used in the United Kingdom to describe an individual or family's lifetime progress from cheaper to more expensive housing. According to this metaphor, cheap houses for first-time buyers are at the bottom of the property ladder, and expensive houses are at the top...
.
This is in contrast with technological or real externalities which have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment. Both pecuniary and real externalities can be either positive or negative.
Under complete market
Complete market
In economics, a complete market is one in which the complete set of possible gambles on future states-of-the-world can be constructed with existing assets without friction. Every agent is able to exchange every good, directly or indirectly, with every other agent without transaction costs...
s pecuniary externalities offset each other. For example, if I buy whiskey and this raises the price of whiskey, the 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.
As a result, some economists have suggested that pecuniary externalities aren't really externalities and shouldn't be called such.
However, when markets are incomplete or constrained, then pecuniary externalities are relevant for Pareto efficiency.
The reason is that under incomplete markets
Incomplete markets
In economics, incomplete markets refers to markets in which the number of Arrow–Debreu securities is less than the number of states of nature...
, the relative marginal utilities of agents are not equated. Therefore a redistribution 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
Financial economics
Financial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....
. 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 constrained Pareto efficient, implying that there is a role for government intervention to mitigate or magnify pecuniary externalities. This is an important welfare-theoretic justification for macroprudential regulation.
For other recent publications on pecuniary externalities see 'Price, C. (2007) Sustainable forest management, pecuniary externalities and invisible stakeholders. Forest Policy and Economics 9: 751-762.' An early reference that makes use of this terminology is 'Prest, A. R. and R. Turvey (1965) Cost-Benefit Analysis: A Survey. The Economic Journal 75: 683-735. The notion of a 'pecuniary spillover' is also introduced by 'McKean, Roland (1958) Efficiency in Government through Systems Analysis: With Emphasis on Water Resources Development (John Wiley: New York).' McKean notes that economists often make a distinction between technological and pecuniary effects, which may have been true at the time but is not the case today.