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According to answer to this question by KennyLJ., there exists the following definition of externality:

The simple, standard, and broad definition I favor is this:

A decision's effects are called external if they fall on someone other than the decision-maker(s). A positive (negative) external effect is called an external benefit (cost).

Moreover, author of the answer states that given the above definition the following would hold:

"This has the consequence that the" .... "the use/consumption of natural resources is considered an externality."

I have the following questions (I know guidelines recommend sticking to single question but they are all closely related):

  1. Is there any mainstream academic (meaning peer reviewed) textbook, book or article that uses the 'standard' definition provided by KennyLJ and which would present a model (or at least an example) in which consumption of any resource is considered an externality in itself?

  2. Is there any academic textbook, book or article that show any of the above two outside mainstream?

In order to first try to find answer myself I look over the following resources which provide the following definitions of externality:

a) Mankiw and Taylor (2014) Economics 3rd ed, pp239:

"the cost or benefit of one person's decision on the well-being of a bystander (a third party) which the decision maker does not take into account in making the decision." ... "as a result price mechanism does not reflect the true cost of the and benefit of decision.

b) Mankiw (2018) Principles of economics. 8ed.

"An externality arises when a person engages in an activity that influences the well-being of a bystander but neither pays nor receives compensation for that effect. If the impact on the bystander is adverse, it is called a negative externality. If it is beneficial, it is called a positive externality. In the presence of externalities, society’s interest in a market outcome extends beyond the well-being of buyers and sellers who participate in the market to include the well-being of bystanders who are affected indirectly"

c) Mas-Colell Whinston Green (1995) Microeconomic theory pp 352:

"Definition "11.B.1 An externality is present whenever the well-being of a consumer or the production possibilities of a firm are directly affected by the actions of another agent in the economy." .... "When we say 'directly,' we mean to exclude any effects that are mediated by prices."

d) Cowen & Tabarok Modern Principles of Economics 3rd ed (Glossary G-2):

Externalities: external costs or external benefits.

External cost: a cost borne by people other than the consumers or the producers trading in the market. External benefit: a benefit recieved by the people other than the consumers or producer trading in the market.

e) Mueller Public Choice III pp25

An externality occurs when the consumption or production of activity of one individual or firm has an unintended impact on the utility or production function of another individual or firm. ... These activities may be contrasted with normal market transaction in which A's action, say buying the tree, has an impact on B, the seller of the tree, but the impact is fully accounted through the operation of the price system."

f) Varian Microeconomic Analysis 3rd edition pp432:

When the actions of one agent directly affect the enviroment of another agent, we will sa that there is an externality. ... the first theorem of welfare economics does not hold in the presence of externalities. The reason is that there are things that people care about that are not priced.

A common theme seems to be that an externality is an effect that happens to the participants outside the market where actually the externality begins. Also all of the sources above claim that there are markets with no externalities implying that they all agree simple trading in the market itself and supply demand interactions in the market do not create externalities. Hence my last question is as follows:

  1. Is there any mainstream academic textbook, book or article post 1990 where this common theme would not be present?
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  • $\begingroup$ Why -1? What makes the question low quality? $\endgroup$
    – 1muflon1 ♦
    May 10, 2020 at 7:02
  • $\begingroup$ "...an externality is an effect that happens to the participants outside the market where actually the externality begins"---how would this apply to the underprovision/overconsumption of public good? (One possible answer: When there is no market via which agents can internalize externality, all agents are "outside" the market and statement holds vacuously.) $\endgroup$
    – Michael
    May 10, 2020 at 19:40
  • $\begingroup$ "...simple trading in the market itself and supply demand interactions in the market do not create externalities"---this is not true when there are multiple markets where agents may choose to trade. Liquidity created by trading is an externality. $\endgroup$
    – Michael
    May 10, 2020 at 19:42
  • $\begingroup$ @Michael as I read what was written in those textbooks that would be the interpretation. Otherwise I don’t really know how would I interpret it as the textbooks always say that externality must be some effect not already reflected in the price some of the texts even explicitly say that such as as the Coven Tabarok textbook. $\endgroup$
    – 1muflon1 ♦
    May 10, 2020 at 19:50
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    $\begingroup$ Yeah, it's a textbook example. See, for example, Harris's empirical introduction to trading and exchanges. $\endgroup$
    – Michael
    May 10, 2020 at 19:55

1 Answer 1

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A main textbook in environmental economics is Perman et al.'s Natural resource and environmental economics (currently in it's 4th edition, published in 2011). Their definition of an externality is:

"An external effect, or externality, is said to occur when the production or consumption decisions of one agent have an impact on the utility or profit of another agent in an unintended way, and when no compensation/payment is made by the generator of the impact to the affected party."(p.121)

They have a footnote on whether or not the compensation part is actually a necessary classifier, but nothing on the price system itself. In another question I used this definition as such, and have been scolded for it because I included pecuniar externalities.

In any case they treat trading and markets as is, that is in the demonstrated models they do not consider externalities from the trade itself. That being said their definition does not exclude it either so I'm inclined to say that for example the disutility generated from being the 2nd highest bidder in an auction could strictly speaking be classified as an externality. After all it is an unintended effect of the transaction between the buyer and seller.

An extensive discussion on the history of the concept and whether or not pecuniary externalities should play a role is in Verhoef's 1999 essay Externalities here, which was published in the Handbook of Environmental and Resource Economics.

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  • $\begingroup$ Thanks for the source +1 just for that. But since the definition includes “in an unintended way” does it include actual buying or selling. Do the authors consider all market activity to be externality generating? Because any increase in demand affects other people’s utility if it changes the market price $\endgroup$
    – 1muflon1 ♦
    May 11, 2020 at 15:21
  • $\begingroup$ Moreover, the paper you shared says this: "In the presence of externalities, market prices do not reflect full social costs (or benefits), and, for instance, regulatory taxes (or subsidies) are called for to restore the efficient workings of the market mechanism." And moreover also this: "These include the definition of externalities, where it is very important to distinguish between externalities and other unpriced effects." Hence clearly according to authors externalities are unpriced effects $\endgroup$
    – 1muflon1 ♦
    May 11, 2020 at 15:31
  • $\begingroup$ I also managed to get my hands on the 3rd edition of Perman et al (pp7) and they state: "One manifestation of market failure is the phenomenon of ‘externalities’. These are situations where, because of the structure of property rights, relationships between economic agents are not all mediated through markets." Moreover, on page 106 they introduce model of a market with no externalities yet the model clearly allows for prices to change. Moreover, on page 134 they say "n our two-person, two-(private)-commodity, twoinput economy we have worked with ... $\endgroup$
    – 1muflon1 ♦
    May 11, 2020 at 15:49
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    $\begingroup$ @1muflon1 yes as you have correcty found they seem to exclude trading as such, although they never spin out the fine details. And I guess therein lies the heart of the problem, because that still leaves room for the interpretation that if I sell object A by auction to the highest bidder that will leave the second highest bidder disappointed (unintentionally I have decreased their utility) $\endgroup$
    – Maarten Punt
    May 11, 2020 at 15:51
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    $\begingroup$ @1muflon1 will do $\endgroup$
    – Maarten Punt
    May 11, 2020 at 16:21

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