Consumption Externalities, Production Externalities, and the Accumulation of Capital

Abstract

We analyze the effects of consumption and production externalities on the long-run rate of capital accumulation. We show that the importance of consumption externalities depends upon whether or not labor supply is fixed. In the case that it is fixed, they have no long-run effects. Whether they have any distortionary effect on the transitional path depends upon the form of utility function. The effects of production externalities are more pervasive; they exert long-run distortionary effects irrespective of labor supply. The optimal taxation to correct for the distortions created by the externalities is characterized. We analyze both stationary and endogenously growing economies, and while there are many parallels in how externalities impact, there are also important differences.