Pecuniary Externality

Pecuniary Externality in Health Economic Evaluation

In welfare economics, a pecuniary externality is the kind of externality that reaches other people only by moving the prices they pay or receive, with no direct effect on their health or output. When a new NHS service draws nurses out of a tight labour market and pushes up agency rates, the trusts and private hospitals that keep hiring pay more, and the agencies and staff receive that same extra amount. Summed across buyers and sellers, the price rise cancels, so a societal cost-benefit analysis that adds it to the cost of a programme counts the same resources twice. The idea still matters in health economics, because a cost-effectiveness analysis from the NHS perspective counts only some of the people affected, and because markets already distorted by insurance or market power do not let price effects cancel.

Pigou's error and the origin of the distinction

The distinction came out of a 1920s dispute over costs in growing industries. Liebowitz and Margolis, writing in 1994, recount that Arthur Pigou argued that every industry except one with constant costs needed a tax or subsidy to reach efficient output, treating the effect of one firm's expansion on its rivals as one more externality. They call this false, because the extra payments that go to inframarginal inputs as an industry with upward sloping supply expands are rents and not part of the social cost of extra output, a point made by Frank Knight in 1924 and by Ellis and Fellner in 1943.

To make the point clear, Pigou's critics separated pecuniary externalities, which work through the price system, from technological externalities such as pollution and congestion, where real costs or benefits are imposed outside the market. A competitive firm whose extra output lowers the price harms its rivals, but that harm is offset by a transfer of wealth to consumers. In the pecuniary case one side of the market gains what the other side loses, and the market outcome is already the one that would be reached if every such effect were internalised. Internalising the effect piecemeal does harm, since firms that took account of their effects on each other would act as a cartel or monopoly. The technological case, treated on the negative externality and positive externality pages, is the one that justifies a Pigouvian tax or subsidy.

Why a price change cancels in a welfare sum

Welfare economics judges a change by its effect on everyone's surplus. A rise in the price of a good lowers the consumer surplus of the buyers who keep buying it and raises the producer surplus of the sellers by the same amount on those units. The transfer on the units that other buyers still purchase is shown below.

$$T = (p_{1} - p_{0})\, q_{o}^{1}$$

where $T$ is the transfer, $p_{0}$ and $p_{1}$ are the market prices before and after the programme enters the market, and $q_{o}^{1}$ is the quantity that other buyers still purchase at the new price. $T$ appears once as a loss to those buyers and once as a gain to sellers, so it adds nothing to the social cost.

The social cost of the programme is its outlay adjusted for the surplus changes it causes, as follows.

$$SC = B + \Delta L_{o} - \Delta G_{s}$$

where $SC$ is the social cost of the resources the programme uses, $B$ is the programme's outlay at the new price, $\Delta L_{o}$ is the loss of consumer surplus to other buyers, and $\Delta G_{s}$ is the gain in producer surplus to sellers. In a competitive market without other distortions, $SC$ equals the opportunity cost of the resources, namely the value of the units other buyers give up plus the marginal cost of the extra units supplied. This is the logic behind a shadow price for an input bought in a market the programme is large enough to move.

Pecuniary effects in health care markets

Health care has large buyers and scarce inputs, so price effects are common. Monitor's 2015 impact assessment of price caps for agency staff reported an 80% rise in NHS trusts' agency spend between the first quarter of 2011/12 and the second quarter of 2013/14, reaching GBP 3.3 billion in 2014/15. It linked the rise to a demand shock in the market for nurses after the Francis report and the regulation on safer staffing that followed, and wrote that the resulting supply pressures allowed agencies to increase charges. In these terms, the part of the rise driven by extra demand was a pecuniary effect between NHS buyers.

Monitor's case went further. It noted that in well functioning markets price caps risk distorting markets and causing supply shortages, and it made the case for national caps depend on tackling the market power of agency staff and agencies. It proposed caps from 23 November 2015 at 150%, 100% or 55% above national pay rates for different staff groups, falling to 55% for all groups by 1 April 2016.

Insurance creates a second channel. Mirza and Stephens, in a 2025 working paper, model private health insurance with the coinsurance contracts seen in practice and show a pecuniary externality in which individuals ignore the effect of their insurance purchases on the future price of care. In their model people buy too much cover and face an excessive price of care, and reducing coverage at the margin can raise welfare by lowering prices. Here the price effect matters for efficiency because moral hazard has already broken the conditions under which pecuniary effects net out.

Counting price effects in cost-benefit and cost-effectiveness analysis

Appraisal guidance in the welfarist tradition nets transfers out of the social total. The HM Treasury Green Book (2026) states that economic transfers incur a cost to the payer and an equal benefit to the recipient and so do not, in themselves, make society better or worse off. It allows transfers to be entered as offsetting costs and benefits or left out, and requires them in distributional analysis. The price element of a pecuniary externality behaves the same way in the welfare sum. The US Department of Health and Human Services guidelines for regulatory impact analysis (2016) say transfers often can be ignored unless they change behaviour enough to affect net benefits, as when hospitals paid less accept fewer patients. The European Commission's Guide to Cost-Benefit Analysis of Investment Projects (2014) excludes indirect effects in secondary markets because, if those markets are efficient, shadow prices already capture them, and adding them usually double counts.

NICE methods start from a narrower viewpoint. The NICE manual (PMG36) sets the reference-case perspective on costs as the NHS and personal social services (section 4.2.9) and asks for the prices actually paid in the NHS (section 4.4.4). Brouwer and colleagues note that extra-welfarist practice, with its focus on the decision maker being advised, does not always take a societal perspective on costs. From the NHS perspective a price rise on the NHS's own purchases is a real cost, because the supplier's gain falls outside the analysis while the NHS budget pays more. PMG36 section 6.3.1 ties the maximum acceptable ICER to the opportunity cost of programmes displaced from a fixed NHS budget, so higher input prices displace health. Section 4.11.4 lists staff numbers and hours among the knock-on resource effects of a new technology, and section 4.4.19 excludes VAT from economic evaluations but keeps it in the budget impact analysis, handling another transfer by perspective.

Worked example with agency nurse hours for a diagnostic centre

All numbers in this example are illustrative. A regional market for agency nurse hours has supply $p = 20 + 0.002Q$ in GBP per hour, where $Q$ is hours a month, and demand from private hospitals and care homes of $q_{o} = 30{,}000 - 500p$. A new NHS diagnostic centre needs 2,500 hours a month whatever the rate.

1. Market before the centre. Setting supply equal to demand gives $p = 20 + 0.002(30{,}000 - 500p) = 80 - p$, so $p_{0} = 40$ and other buyers purchase 10,000 hours.

2. Market after the centre. Adding 2,500 hours gives $p = 85 - p$, so $p_{1} = 42.50$. Other buyers now purchase 30,000 minus 21,250, or 8,750 hours, and supply rises to 11,250 hours.

3. Outlay. The centre pays 2,500 × 42.50, or GBP 106,250 a month.

4. Other buyers' loss. On the 8,750 hours they keep, they pay 2.50 more, a transfer of GBP 21,875. On the 1,250 hours they give up, they lose a triangle of 0.5 × 2.50 × 1,250, or GBP 1,562.50. Their loss is GBP 23,437.50.

5. Sellers' gain. Producer surplus rises from 0.5 × 20 × 10,000, or GBP 100,000, to 0.5 × 22.50 × 11,250, or GBP 126,562.50, a gain of GBP 26,562.50.

6. Social cost. The second equation gives 106,250 + 23,437.50 minus 26,562.50, or GBP 103,125. As a check, the 1,250 hours other buyers release are worth GBP 41.25 each on average, and the 1,250 new hours cost GBP 41.25 each on average to supply, so 2,500 × 41.25 gives GBP 103,125.

7. The common error. In a societal analysis, adding the other buyers' loss of GBP 23,437.50 to the outlay without the sellers' gain gives GBP 129,687.50, overstating the social cost by GBP 26,562.50, about 26%.

8. The NHS view. If the other buyers were instead NHS trusts, the agencies' gain falls outside the NHS and PSS perspective while the trusts' extra GBP 21,875 a month on the 8,750 hours they keep stays in as an NHS cost, and the 1,250 hours they give up count as care forgone rather than as a saving. Over a year the extra payment is 12 × 21,875, or GBP 262,500, which at GBP 25,000 per QALY, a value PMG36 section 6.3.2 uses for presenting net health benefit, corresponds to 10.5 QALYs of health displaced elsewhere.

9. Interpretation. The same price rise is a transfer in a societal cost-benefit analysis and a real cost in a cost-effectiveness analysis from the NHS perspective, because the two count different people's surplus.

When a pecuniary effect changes efficiency

Price effects net out only when the market where they occur is competitive and complete. The European Commission guide, citing Boardman, adds that if a secondary market is inefficient and the project is large enough to move its prices, the extra welfare effects should be counted. Greenwald and Stiglitz, in a 1984 working paper on economies with imperfect information and incomplete markets, separate the traditional pecuniary effect, which nets out, from the remaining effects, which simplifies judging when a tax intervention can be Pareto improving.

Pooled insurance shows the split between transfer and distortion. Bhattacharya and Sood argue that when premiums are not rated for obesity, people with obesity impose a negative externality on others in their pool. If weight did not respond to the implicit subsidy, it would simply be a transfer between thinner and heavier members with no net effect on social welfare. The welfare loss arises because incentives to lose weight are weaker, which they estimate at about USD 150 per person in 1998 dollars in a plan with 17.5% coinsurance, lower than published estimates of the transfer.

Boundaries and common errors

A pecuniary externality differs from a technological one in how the effect travels. Herd protection from vaccination, set out on the vaccination externalities page, is technological, since the protection reaches the unvaccinated without any price changing. Price effects that arise because a market is already distorted belong with market failure and the theory of the second best.

1. Counting secondary market price changes as programme benefits or costs. In an efficient market this double counts what shadow prices already measure.
2. Dropping price effects that land inside the payer's own budget. From the NHS perspective a rise in input prices for other trusts is a cost.
3. Ignoring who gains and who loses. A transfer that nets to zero still changes the distribution of income, which the Green Book requires distributional analysis to show.
4. Calling every market response a pecuniary externality. A price rise caused by market power, or a premium subsidy that changes behaviour, carries a real efficiency cost.

Sources

• Bhattacharya J, Sood N. Health insurance and the obesity externality. NBER Working Paper 11529. National Bureau of Economic Research; July 2005. https://www.nber.org/papers/w11529
• Brouwer WBF, Culyer AJ, van Exel NJA, Rutten FFH. Welfarism vs. extra-welfarism. Journal of Health Economics. 2008;27(2):325-338. https://doi.org/10.1016/j.jhealeco.2007.07.003
• European Commission, Directorate-General for Regional and Urban Policy. Guide to Cost-Benefit Analysis of Investment Projects: Economic appraisal tool for Cohesion Policy 2014-2020. December 2014. Section 2.8.10. https://ec.europa.eu/regional_policy/sources/studies/cba_guide.pdf
• Greenwald B, Stiglitz JE. Pecuniary and market mediated externalities: towards a general theory of the welfare economics of economies with imperfect information and incomplete markets. NBER Working Paper 1304. National Bureau of Economic Research; March 1984. https://www.nber.org/papers/w1304
• HM Treasury. The Green Book (2026). Updated 28 October 2026. https://www.gov.uk/government/publications/the-green-book--2/the-green-book-2026
• Liebowitz SJ, Margolis SE. Network externality: an uncommon tragedy. Journal of Economic Perspectives. 1994;8(2):133-150. https://doi.org/10.1257/jep.8.2.133
• Mirza A, Stephens E. On the over-provision of medical insurance. Carleton Economics Working Paper CEWP 25-02. Carleton University; 2025. https://carleton.ca/economics/wp-content/uploads/sites/112/cewp25-02.pdf
• Monitor. Price caps for agency staff: impact assessment. Publication code IRG 32/15. 15 October 2015. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/468469/Impact_assessment_-_agency_rules.pdf
• National Institute for Health and Care Excellence. NICE technology appraisal and highly specialised technologies guidance: the manual (PMG36). Published 31 January 2022, last updated 13 October 2026. Sections 4.2.9, 4.4.4, 4.4.19, 4.11.4, 6.3.1 and 6.3.2. https://www.nice.org.uk/process/pmg36
• US Department of Health and Human Services, Office of the Assistant Secretary for Planning and Evaluation. Guidelines for Regulatory Impact Analysis. 2016. https://aspe.hhs.gov/sites/default/files/migrated_legacy_files/171981/HHS_RIAGuidance.pdf