On the definition of externality as a missing market

Despite its increasing role in economic theory, the concept of externality seems to elude any attempt at rigorous and consensual definition. While problems of definition have emerged with the concept itself in the 1950s, the paper focuses on the definition of externality within the general equilibrium theory. In the Arrow-Debreu framevork, externality is a kind of "missing market" (Arrow 1969) – an unpriced effect that upsets the assumption of the complete system of markets – and its formalization is achieved by introducing a direct interdependence between utility or production functions. The paper shows that this Arrovian definition allows some ambiguities to persist. As witnessed by some authors' positions in the 1970s (Mishan 1971, Baumol and Oates 1975, Heller and Starrett 1976, Laffont 1988), it does not highlight two features associated with the traditional meaning of externalities: whether or not it is an exogenous effect and an unintended effect. This raises, although differently, the issue of the dilution of externality within the larger notion of individual interdependences. Beyond the conceptual importance of clarifying the definition of externality, this issue has also a strong normative content: giving a strict definition of externality amounts, implicitly, to drawing the frontier of legitimate internalisation and economic policy.