Externality, Convexity and Institutions

Abstract

Economic theory has generally akcnowledged the role that institutions have in shaping economic space. The distinction however between physical and institutional descriptions of economic activity has not received adequate attention within the mainstream paradigm. In this paper I show how a proper distinction between the physical and institutional space in economic models will help clarify the concept of externality and provide a better interpretation of the relationship between externality and nonconvexity. I argue that within the Arrow-Debreu framework externality should be viewed as incongruence between the physical and institutional descriptions of the economic space. Accordingly the only consistent characterisation of externality is to view it as synonymous with missing markets or missing property rights. All that distinguishes a conventional commodity from an externality is the extent to which a market exists for the "good" in question. The common expression "markets for externalities" is misleading since it tends to imply that there is more to externality than simply the non-existence of a market. It is most likely the result of confounding certain kinds of jointness in production with externality. I also argue that contrary to conventional wisdom, detrimental externality has no special association with nonconvexity. Starrett's (1972) fundamental nonconvexity has to do with the specific institutional structure of Arrow markets rather than the detrimental nature of externality. Indeed, Arrow markets will not in general eliminate externalities. In a similar vein it is not detrimental externality, however intense, that causes the production possibility set to become nonconvex as argued by Baumol and Bradford (1972), but the particular interpretation of intensity that would make even conventional production possibility sets nonconvex. These points become apparent when one distinguishes between the convexity of the physical and institutional production sets. An understanding that "externality" is purely an institutional construct will assist in a proper appraisal of the critical economic function of institutions.

Keywords: microeconomics, organisational behaviour, transaction costs, property rights, incomplete market, externalities

JEL Classification: D00, D23, D52, D62