CONSUMPTION EXTERNALITIES AND ECONOMIC WELFARE Randall G. Holcombe Florida State University and Russell S. Sobel West Virginia University INTRODUCTION In a market economy, almost every action undertaken by an individual orbusi- nessfirm will either directly or indirectly affect the welfare of other nonconsenting parties. These third-party effects, generally called externalities, often serve as a call for corrective action by the government. Inthe caseof externalities between business firms, previous literature hasshown that for public policy purposes there is an impor- tant distinction between technological and pecuniary externalities. The case of 'Sturges v. Bridgman, made famous inRonald Coase's[1960] article, "The Problem of Social Cost," involves confectioner Bridgman's machinery emitting noise and vibration that interfered with Dr. Sturges's ability to use his consulting room, thus lowering Dr. Sturges's profits. This is an example of a technological externality because the noise and vibration from the machinery directly affected the production process of Dr. Sturges. However, consider an alternative scenario inwhich a new doctor opened up next door toDr. Sturges and began competing with him for business, equivalently lowering Dr. Sturges's profits. This would instead bean example of a pecuniary externality that in no way caused a market inefficiency. Thus, despite both types of externalities result- ing in equivalent welfare losses to Dr. Sturges, only the technological externality interferes with efficiency and is thus potentially a concern for corrective government policy. While technological externalities cancreate market failures andviolations of Pareto efficiency, pecuniary externalities can not. In fact, the presence ofuncor- rected pecuniary externalities is necessary for the efficient operation of markets. This distinction istherefore of the utmost importance inthe conduct of policy. Despite this apparently clear distinction between technological and pecuniary externalities in pro- duction, nosuch clear distinction is currently present with respect toexternalities in consumption, or externalities between individuals. A smoker, for example, may lower the utility of a nonsmoking companion not only by the potentially harmful effects from the second-hand smoke, but also by a concern for their health orthe lost years Randall G. Holcombe: Department of Economics, FloridaState University, Tallahassee, Florida 32306-2180. E-mail: holcombe@garnet.acns.fsu.edu Eastern Economic Journal, Vol. 26, No. 2, Spring 2000 157