Correcting Market Failure Due to Interdependent Preferences: When Is Piecemeal Policy Possible?

Emanuela Randon () and Peter Simmons

Discussion Papers from Department of Economics, University of York

Abstract: Generally, implementation of Pigovian taxes to correct for market failure requires an enormous set of information. For each commodity-person combination a different tax is required to correct the resulting market inefficiency. In this paper, we analyse interdependent preferences and inefficiency of the market solution with the aim of finding conditions justifying simple rules for such taxes. We examine the utility possibility curve and Scitovsky community indifference curve, allowing for general utility interdependence and agent heterogeneity. In particular we show the equivalence of taxes derived from the Marshallian and compensated demand approaches. We move on to analyse the welfare cost of consumption externalities and show that it decomposes into part due to individuals choosing suboptimal quantities and part due to individuals using valuations that are not socially optimal. We show what forms of externality can justify simple policy corrections. In particular, we analyse the conditions which are required for the market failure to be corrected by: 1) specific indirect ad valorem taxes on commodities, 2) the same proportional tax rate on every commodity, 3) a proportional income tax rate on each individual. The conditions are related to the restrictions necessary to have H synthetic consumers without externalities who replicate behaviour of individuals with externalities. An example with two individuals and three goods concludes the paper.

Keywords: Consumption externalities; Piecemeal policy (search for similar items in EconPapers)
JEL-codes: D11 D62 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mic
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Journal Article: Correcting Market Failure Due to Interdependent Preferences: When Is Piecemeal Policy Possible? (2007)
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