Notes on Market Failure and the Paretian (Kaldor-Hicks) Relevance and Irrelevance of Unfavourable Externalities

The following are notes that have been distributed by me over the last few years to students in Environmental Economics at The University of Queensland. They give particular attention to whether externalities are Pareto or Kaldor-Hicks relevant from a policy point of view. Externalities are Kaldor-Hicks or Pareto irrelevant if no change is possible for which gainers could compensate losers. Both absolute and marginal externalities may be Kaldor-Hicks relevant. Infra-marginal negative externalities are often, but not always, Kaldor-Hicks irrelevant. There are at least two cases where such externalities can be relevant. First, the absolute impact of the negative externality may be so great that the source of the externality should be eliminated. Secondly, if the externality arises from production, its nature may depend on the type of production technique adopted. Although for the technique adopted, an infra-marginal negative externality occurs. That is Paretian irrelevant given that choice of this technique is the only available possibility, alternative techniques may actually be available in practice. Some of these may generate even smaller total external effects and be socially preferable. Both cases are outlined and illustrated in these notes. The analysis reveals the dangers of relying on marginalism for deciding on environmental policy. Total (external) effects are often of great social and economic importance and appropriate social choices cannot be made on the basis of marginalism alone.