On the Core of an Economic System with Externalities

by Lloyd S. Shapley, Martin Shubik

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An investigation of the social stability of joint undertakings to allocate costs or benefits of the external effects of productive economic activity. Social stability is taken to mean that all coalitions or potential coalitions of affected parties are satisfied simultaneously. This is equivalent to being in the core of the corresponding multiperson game. Externalities may be economic (beneficial) or diseconomic (detrimental) to the welfare of affected outside parties. For economic systems without externalities, a core is known to exist under quite general conditions on the production and utility functions. It is demonstrated that this remains true in the case where the only externalities are economic, but that it can fail if diseconomies are present. A number of simple pollution-type models that have a wide diversity of core behavior are examined. Tax and subsidy schemes are discussed in regard to their potential for the achievement of Pareto optimality in the face of externalities of both types.

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