Efficiency and Equity in Externalities: A Partial Equilibrium Analysis

Externalities comprise efficiency aspects and equity aspects. The potential Pareto improvement criterion usually applied in analysis of the economics of externalities is solely concerned with efficiency aspects because it bypasses the question of interpersonal utility comparison. However, in the practice of policymaking, equity issues are often at least as important. This paper contains a partial equilibrium analysis of the question of to what extent optimization and compensation of an external cost are compatible under different schemes of regulation and internalization, and in different model settings: the standard textbook model, a model in which defensive activities on behalf of the victim are allowed for, and a model in which dynamic aspects of entry—exit behaviour are investigated.