Consumption Externalities and Imperfect Corrective Pricing

Abstract

Pricing congested facilities above marginal production cost is a conventional approach to improving resource allocation. Where everyone is producing the same externality, a uniform price (in excess of marginal cost by the value of the externality) permits the competitive equilibrium to be Pareto optimal. Where individuals give rise to different externalities, but a uniform price is in effect, we have a second-best situation. When demands depend only on price, price should exceed marginal cost by a weighted average of externalities generated, the weights being the price derivatives of demand. When demands also depend on congestion, the optimal price generally diverges from this rule. The price should be lower when the individuals giving large external diseconomies per unit demanded tend to be price insensitive and congestion sensitive in their demands (relative to the average). In this case public expenditures to decrease congestion directly should not be carried to the point where the marginal direct benefit from congestion reduction equals the marginal cost. Optimal income distribution is also examined.

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