MARKET DECENTRALIZATION UNDER EXTERNALITIES WITH VETO-PROOF REGULATION

Source abstract

How should government regulate an economy when externalities are present? We study an Arrow-Debreu economy with production and consumption externalities, with a focus on production externalities. We develop a mixed economy framework in which government regulation interacts with market forces: regulations are modeled as constraints on production sets, taken as exogenous by firms but chosen endogenously by the government to achieve desirable market outcomes. With production externalities, a firm may have the ability to veto a desired allocation by making other firms' production plans infeasible. We define a regulation to be veto-proof if it removes this unilateral veto power. We prove a Second Welfare Theorem for Mixed Economies: every consumption-production pair satisfying a Separation Condition can be supported as a Walrasian equilibrium with transfers under any veto-proof regulation, using uniform, rather than personalized, prices. Unlike the classical second welfare theorem, our result can support some allocations that are desirable but not Pareto optimal, which is important when governments cannot identify true Pareto optima. In examples on pollution control, education as infrastructure, the Tragedy of the Commons, and technological innovation, simple veto-proof regulations eliminate undesirable market outcomes, deliver Pareto improvements over unregulated equilibria, and can even achieve Pareto optimal outcomes.