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Externalities in economic thought

Editors of the special issue: Steven G. Medema and Samuel Ferey

Deadline for submission: September 1st, 2014.

Planned publication of the issue: 2015.

Over the last sixty years, the concept of externality has become prominent within economics. It is common knowledge that the concept was first discussed by Marshall and then given an analytical content by Pigou (1920) in The Economics of Welfare, in which he analyzed the divergence between marginal private interest and marginal social interest in case of a negative externality and proposed to implement a tax system on polluting activities. Since Meade’s (1952) now classic presentation of the effect of an externality through the fable of the apple grower and the beekeeper, the concept of externality has gained visibility in mainstream economic analysis. It has fostered a vast literature and many debates between economists intent on refining the definition and the actual scope of the concept. Despite this collective effort, Heller and Barttlett (1976) could still complain in the mid-1970s that the concept, intuitive as it is, must remain somewhat imprecise.

On the one hand, the concept has proven to be analytically protean, it has received many different interpretations and analytical expressions, each pertaining to a certain understanding of what constitutes the gist of the explanation attached to the very idea of an externality: some kind of direct relation between two agents (two producers, two consumers) taking place beyond the reach of the market’s pricing mechanism. Attempts to delineate the idea of an external effect have lead different traditions in economics to stress the close links of externality with Pareto-optimality, missing markets, lack of information, transaction costs, public goods, and market failures.

On the other hand, the concept of externality opened up a variety of to operational definitions, with specific tools attached to the quantification of its effects on economic outcomes, especially in the field of cost-benefit analysis. This operationalization and the meanings attached to ‘externality’ have become so diverse and widespread that it is now integrated in many fields of economics (monetary theory, finance, development, ecological economics, network economics, housing economics, etc)—going well beyond the concept’s original narrow confines. Many of these fields of research possessed their own specific category of externality (neighborhood externalities, network externalities, knowledge spillovers, …) affecting the market equilibrium.

This historical development of externality raises many questions of interest to historian of economic thought, and beyond.

One potential argument pertaining to the catch-all content of the concept deals with its doctrinal role within the debate between the General competitive equilibrium tradition (and its conception of optimality and welfare) and the Chicago approach to externality, centered on the partial equilibrium framework and devoted to exploring the consequences of the Coasean solution to the problem of social cost (Coase (1960), Buchanan and Stubblebine (1962), Dahlman (1979)). Each tradition offers a different way of connecting the concept of externality with the main representation of market failures, transaction costs, Pareto-optimality and more broadly, market coordination. As far as the Chicago tradition is concerned, a central argument deals with the potential to take benefit of some positive externalities at the level of transaction costs in order to internalize them.

Another question of importance deals with the history of the declension of the concept in different subfields of economics. The concept spawned from industrial regulation to a vast range of other fields (finance, development, law and economics, geographical economics, housing and urban economics, network economics, knowledge economics, environmental economics, …). This diffusion opens up to different classes of formalization and modeling in relation to a wide range of interpretations and of possible debates about the “right” way to model externalities.

Externalities also have been more and more associated with issues related to property rights and transaction costs, thus shifting the discussion away from traditional welfare economics analysis. When externalities are associated with transaction costs, the competitive benchmark becomes elusive and absolute externalities give way to relative externalities and to a comparative analysis of different institutional settings. Thus, institutions enter more readily into the usual free market/government tradeoff and open up the consideration of a spectrum of institutional patterns—including large-scale vs. small-scale and public vs. private institutions as the forms best suited to deal with particular situations of externality. The specific role of externalities in fostering this evolution deserves to be studied.

Externalities have been also a subject of experimentations. Experimental economics has studied the way subjects placed in situations of social dilemmas solve —or fail to solve—conflicts ranging from simple two-party externalities to tragedies of the commons, and how these solutions are shaped by different social institutions. One may reasonably wonder what this literature adds to our understanding of externalities. Does it help identifying the institutional parameters that reduce or increase transaction costs? Does it favor alternative models of human behavior in cases of externalities, departing from the usual definition of rational behavior? What are the consequences attached for policy design that would result?

Beyond history of economic thought, the concept of externality has also been influential on the methods of economic history, fostering new themes and techniques to deal with externality at a macroeconomic and long-wave level.

Externalities have become also a matter of economic ethics and normative economics, at least since Arrow (1969 and 1973) introduced the topic of ethical codes as a way to deal with some information asymmetries and missing markets due to transaction costs. Indeed, the discussions of externality are often bound up in issues of intentionality, responsibility, and causation attached to the person or group said to be the source of the externality. It is thus a matter of economic ethics to discuss the types of values that a society should support and the types of externalities it should discourage as an alternative to the implementation of market solutions when transaction costs are too high or when they can be reduced through the development of collective values or social conventions. More broadly, the concept of externality conveys, at least implicitly, claims about the scope and boundaries of the market.

With these general themes in mind, Œconomia – History / Methodology / Philosophy wishes to publish a panel of articles dealing with the history and philosophy of externality in economics.

A non exhaustive list of potential subjects includes:

  • History of analytical definitions of externality, dealing with its specific relations with other meta-theories in which the concept is likely to evolve.

  • History of the Chicago/GET opposition in the light of the concept of externality, and what it reveals about different ways to tackle the issue of external values and market coordination.

  • History of the Chicago School/Virginia School approaches to externality.

  • Use of the concept of externality in economic history: how it has been introduced, with what kind of definition and what techniques of quantification?

  • Topics on the governance of international public goods.

  • Ethical issues linked with externalities, confronting local and global solutions.

  • Externalities in the Pigovian tradition.

  • The place of externalities within different trends of institutional economics.

  • The modeling of externality from Meade and Scitovsky to the present.

  • Pre-marginalist and early marginalist accounts of externalities (including Marshall and Pigou).

  • The conceptual overlap between public goods, externalities and merit goods.

Authors are invited to express their interest to participate in the special issue by November 15th, by sending an e-mail to or by November 15th (indicating the main theme of their contribution). Articles shall be submitted at: http://www.editorialmanager/oec. For any complementary question, please contact us at


Arrow, Kenneth J. 1969. The organization of economic activity: Issues pertinent in the choice of market versus non-market allocation. In Public expenditure and policy analysis, R. H. Haveman and J. Margolis (eds), 59-73. Chicago: Markham

Arrow, Kenneth J. 1973. Social responsibility and economic efficiency. Public policy, 21, 303-317

Buchanan, James M. and William Craig Stubblebine. 1962. Externality. Economica, 29(116): 371-384

Coase, Ronald H. 1960. The problem of social cost. Journal of Law and Economics, 3(1): 1-44.

Dahlman, Carl J. 1979. The problem of externality. Journal of Law and Economics, 22(1): 141-162

Heller, Walter Perrin and David A. Starrett. 1976. On the nature of externalities. In Theory and measurement of externalities, Lin Say (ed.), 9-21. New York: Academic Press

Meade, James E. 1952. External economies and diseconomies in a competitive situation. Economic Journal, 62: 54-67

Pigou, Arthur Cecil. 1920. The Economics of Welfare. 4th ed. London: Macmillan

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