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A Market Based Solution to Price Externalities: A Generalized Framework

  • Weerachart T. Kilenthong
  • Robert M. Townsend

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.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 20275.

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Date of creation: Jul 2014
Date of revision:
Handle: RePEc:nbr:nberwo:20275
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  1. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
  2. Edward Simpson Prescott & Robert M. Townsend, 2006. "Firms as Clubs in Walrasian Markets with Private Information," Journal of Political Economy, University of Chicago Press, vol. 114(4), pages 644-671, August.
  3. Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2009. "A Theory of Liquidity and Regulation of Financial Intermediation," Review of Economic Studies, Oxford University Press, vol. 76(3), pages 973-992.
  4. Kilenthong, Weerachart & Townsend, Robert, 2010. "Information-Constrained Optima with Retrading: An Externality and Its Market-Based Solution," MPRA Paper 20725, University Library of Munich, Germany.
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  17. John Geanakoplos & H. M. Polemarchakis, 2008. "Pareto Improving Taxes," Cowles Foundation Discussion Papers 1662, Cowles Foundation for Research in Economics, Yale University.
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  20. Brian Begalle & Antoine Martin & James J. McAndrews & Susan McLaughlin, 2013. "The risk of fire sales in the tri-party repo market," Staff Reports 616, Federal Reserve Bank of New York.
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