Charles Goetz, James Buchanan, External production diseconomies
Macroeconomics | Public Economics
In a recent article in this Review, Charles Goetz and James Buchanan (G-B) assert that " . . . the standard description of misallocation in the presence of external production diseconomies is misleading . . . " because these externalities produce a ". . . combination of exchange-inefficiency with production-inefficiency [which ] renders the construction of correction devices much more difficult" (p. 889). Stated otherwise their contention is that with external diseconomies that are internal to an industry, i.e., those that each firm in an industry inflicts on other firms in the same industry, a competitive regime in the presence of a per unit tax on output designed to eliminate the difference between private and social marginal cost will not achieve a Pareto optimum. The competitive equilibrium even after the imposition of the corrective tax lies inside the production possibilities frontier.
The purpose of this note is to suggest that the G-B analysis while technically correct is based on a set of assumptions that differs in a particular aspect from what we believe to be the assumptions of the neoclassical paradigm. Moreover within the framework of the neoclassical model we show the standard prescription regarding a corrective tax to be correct. As it turns out, the difference between the G-B model and the neoclassical model is likely to be negligible in any meaningful application but in any case we show that in the G-B model, a lump sum tax imposed on top of the standard Pigovian per-unit tax will restore full Pareto optimality.
Hay, George A. and McGowan, John J., "External Diseconomies in Competitive Supply: Comment" (1973). Cornell Law Faculty Publications. 1163.
Published in: American Economic Review, vol. 63, no. 4 (September 1973).