Pecuniary Externality

A pecuniary externality is an externality which operates through prices rather than through real resource effects. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to get onto the property ladder.

This is in contrast with technological or real externalities which have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment. Both pecuniary and real externalities can be either positive or negative.

Under complete markets pecuniary externalities offset each other. For example, if I buy whiskey and this raises the price of whiskey, the consumers of whiskey will be worse off and the producers of whiskey will be better off. However, the loss to consumers is precisely offset by the gain to producers; therefore the resulting equilibrium is still Pareto efficient. As a result, some economists have suggested that pecuniary externalities aren't really externalities and shouldn't be called such.

However, when markets are incomplete or constrained, then pecuniary externalities are relevant for Pareto efficiency. The reason is that under incomplete markets, the relative marginal utilities of agents are not equated. Therefore the welfare effects of a price movement on consumers and producers do not generally offset each other.

This inefficiency is particularly relevant in financial economics. When some agents are subject to financial constraints, then changes in their net worth or collateral that result from pecuniary externalities may have first order welfare implications. The free market equilibrium in such an environment is generally not constrained Pareto efficient, implying that there is a role for government intervention to mitigate or magnify pecuniary externalities. This is an important welfare-theoretic justification for macroprudential regulation.

For other recent publications on pecuniary externalities see 'Price, C. (2007) Sustainable forest management, pecuniary externalities and invisible stakeholders. Forest Policy and Economics 9: 751-762.' An early reference that makes use of this terminology is 'Prest, A. R. and R. Turvey (1965) Cost-Benefit Analysis: A Survey. The Economic Journal 75: 683-735. The notion of a 'pecuniary spillover' is also introduced by 'McKean, Roland (1958) Efficiency in Government through Systems Analysis: With Emphasis on Water Resources Development (John Wiley: New York).' McKean notes that economists often make a distinction between technological and pecuniary effects, which may have been true at the time but is not the case today.