Production Externalities and Expectations Application to the Economics of Climate Change

In this paper, we extend the problem of decentralization of Pareto optima in an economy with production externalities to the case where the production capacities upon which Pareto optimality is defined may differ from the aggregate of the firms expectations about their production possibilities. This issue is raised in order to deal with the seemingly different expectations of firms and governments about the economic consequences of climate change. We show the government can create a "production allowance" market in order to force the firms to produce in a way it considers as optimal. The results are then applied to the analysis of the economic and welfare consequences of climate change.