A Market Based Solution to Price Externalities: A Generalized Framework

66 Pages Posted: 8 Jul 2014

See all articles by Weerachart Kilenthong

Weerachart Kilenthong

University of the Thai Chamber of Commerce

Robert M. Townsend

Massachusetts Institute of Technology (MIT)

Date Written: July 2014

Abstract

Pecuniary externalities have regained the interest of researchers as they seek policy interventions and regulations to remedy externality-induced distortions, e.g., balance sheet effects, amplifiers and fire sales. In this paper we go back to first principles and show how to design financial contracts and markets in such a way that ex ante competition can achieve a constrained-efficient allocation. The key as in general equilibrium theory is to extend the commodity space in such a way that bundling, exclusivity and additional markets internalize these pecuniary externalities. We devise in this paper a general way of proceeding that covers as a general case the large variety of example-economies which differ from one another in the particular source of the constraint generating the externality. A key take away from our approach is that we do not need to identify and quantify some policy intervention. With the appropriate ex ante design we can let markets solve the problem.

Suggested Citation

Kilenthong, Weerachart and Townsend, Robert M., A Market Based Solution to Price Externalities: A Generalized Framework (July 2014). NBER Working Paper No. w20275. Available at SSRN: https://ssrn.com/abstract=2463390

Weerachart Kilenthong (Contact Author)

University of the Thai Chamber of Commerce

Robert M. Townsend

Massachusetts Institute of Technology (MIT) ( email )

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Cambridge, MA 02139-4307
United States

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