Externalities in Economics and Finance: Essays on spillover effects and economic decisions
Investment, production, and consumption decisions of agents may affect other agents who are outside of the transaction, thereby imposing an externality on them. A person exposed to externalities often internalizes these externalities in their decision-making process. For example, when investors are forced to sell an asset within a limited time frame at fire sale prices, similar assets are indirectly impaired through negative price spillovers. Therefore, investors that would absorb more of these spillovers may have incentives to incorporate the likelihood of future externalities in their ex-ante portfolio decisions. The existence of externalities and associated economic inefficiency also makes a case for policy intervention, for example by a Government. Depending on the nature of the externality, the Government may decide to intervene to prevent individually rational, but socially wasteful behavior, thereby generating benefits for market participants and for society. If governmental bodies have limited scope, the positive effects of a policy can even indirectly spill over to other assets or other agents not directly supervised by the authority, in which case coordination between policymakers in different jurisdictions would further increase efficiency. As the presence and size of externalities often justify Government intervention, studying the propagation of spillover effects across different market participants is an important requirement to understand optimal policy design.