Externalities in Economies with Imperfect Information and Incomplete Markets

This paper presents a simple, general framework for analyzing externalities in economies with incomplete markets and imperfect information. By identifying the pecuniary effects of these externalities that net out, the paper simplifies the problem of determining when tax interventions are Pareto improving. The approach indicates that such tax interventions almost always exist and that equilibria in situations of imperfect information are rarely constrained Pareto optima. It can also lead to simple tests, based on readily observable indicators of the efficacy of particular tax policies in situations involving adverse selection, signaling, moral hazard, incomplete contingent claims markets, and queue rationing equilibria.