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Correcting Market Failure Due to Interdependent Preferences: When Is Piecemeal Policy Possible?

Generally, implementation of Pigovian taxes to correct for market failure requires an enormous set of information. For each commodity-person combination a different tax is required to correct the resulting market inefficiency. In this paper, we analyse interdependent preferences and inefficiency of the market solution with the aim of finding conditions justifying simple rules for such taxes. We examine the utility possibility curve and Scitovsky community indifference curve, allowing for general utility interdependence and agent heterogeneity. In particular we show the equivalence of taxes derived from the Marshallian and compensated demand approaches. We move on to analyse the welfare cost of consumption externalities and show that it decomposes into part due to individuals choosing suboptimal quantities and part due to individuals using valuations that are not socially optimal. We show what forms of externality can justify simple policy corrections. In particular, we analyse the conditions which are required for the market failure to be corrected by: 1) specific indirect ad valorem taxes on commodities, 2) the same proportional tax rate on every commodity, 3) a proportional income tax rate on each individual. The conditions are related to the restrictions necessary to have H synthetic consumers without externalities who replicate behaviour of individuals with externalities. An example with two individuals and three goods concludes the paper.

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Paper provided by Department of Economics, University of York in its series Discussion Papers with number 05/12.

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Handle: RePEc:yor:yorken:05/12
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  1. Pollak, Robert A, 1976. "Interdependent Preferences," American Economic Review, American Economic Association, vol. 66(3), pages 309-20, June.
  2. Blackorby, C. & Davidson, R. & Schworm, W., 1990. "The Validity Of Piecemeal Second-Best Policy," G.R.E.Q.A.M. 90a18, Universite Aix-Marseille III.
  3. Peter Kooreman & Lambert Schoonbeek, 2004. "Characterizing Pareto Improvements in an Interdependent Demand System," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 6(3), pages 427-443, 08.
  4. Jewitt, Ian, 1981. "Preference structure and piecemeal second best policy," Journal of Public Economics, Elsevier, vol. 16(2), pages 215-231, October.
  5. Kapteyn, A. & Van De Ger, S. & Van De Stadt, H. & Wansbeek, T., 1989. "Interdependent Preferences: An Econometric Analysis," Papers 8954, Tilburg - Center for Economic Research.
  6. Guoqiang Tian, 2004. "A Unique Informationally Efficient Allocation Mechanism In Economies With Consumption Externalities," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(1), pages 79-111, 02.
  7. Milleron, Jean-Claude, 1972. "Theory of value with public goods: A survey article," Journal of Economic Theory, Elsevier, vol. 5(3), pages 419-477, December.
  8. Pollak, Robert A, 1970. "Habit Formation and Dynamic Demand Functions," Journal of Political Economy, University of Chicago Press, vol. 78(4), pages 745-63, Part I Ju.
  9. Tibor Scitovsky, 1954. "Two Concepts of External Economies," Journal of Political Economy, University of Chicago Press, vol. 62, pages 143.
  10. Bergstrom, Theodore C., 1970. "A "Scandinavian consensus" solution for efficient income distribution among nonmalevolent consumers," Journal of Economic Theory, Elsevier, vol. 2(4), pages 383-398, December.
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