Externality
An externality is a cost or benefit imposed on a third party that is not priced in the original transaction — fire sales, contagion, and pollution are the same object in different clothes.
Definition
Private MC ≠ social MC (or MB). Negative externalities are over-produced; positive ones under-produced. Fire-sale spirals are pecuniary externalities: one book’s liquidation moves prices and binding constraints for others even if every trade is ‘voluntary.’
Why it matters
Systemic risk is an externality. Micro-prudential ‘each bank is solvent’ can still produce a cascade because price impact is not internalized.
Case
A dealer dumping MBS in 2008 was individually rational and socially costly: the price path tightened haircuts on everyone else. That is why macro-pru exists.
How to read it
Separate technological externalities from pecuniary ones. Only the latter need a financial-stability tool; both can look like ‘contagion’ on a chart.
Key papers
Landmark references with real publisher or arXiv links — not token-overlap noise.
- The Economics of WelfarePigou · 1920 · MacmillanPigouvian externalities.