Theory of negative consumption externalities with applications to the economics of happiness

This paper investigates the problem of obtaining Pareto efficient allocations in the presence of negative consumption externalities. In contrast to the conventional wisdom, we show that even if consumers’ preferences are monotonically increasing in their own consumption, one may have to dispose of resources to achieve Pareto efficiency when negative consumption externalities exist. We provide characterization results on destruction both for pure exchange economies and for production economies. As an application, our results provide an explanation to Easterlin’s paradox: average happiness levels do not increase as countries grow wealthier. We thank an anonymous referee, Xiaoyong Cao, Li Gan, and Tapan Mitra for helpful comments and suggestions that improved the exposition of the paper. The first author thanks the National Natural Science Foundation of China and Private Enterprise Research Center at Texas A&M University for financial support.