Externalities In The Edgeworth Box

The effect of the presence of an externality in a general equilibrium scenario is illustrated in a standard Edgeworth box. Assuming utility functions parameterized by the incidence of the externality and taking into account the resource constraints when deriving agents’ indifference curves for consumption distributions renders possible to depict contract curves with and without the externality in the same box. The introduction of a market for the right to generate the externality extends the Second Welfare Theorem to hold in the presence of an externality, too. In doing this a novel and strikingly simple graphical procedure is developed to obtain the complete picture.