Introduction To Macroeconomic Dynamics Special Issue: Public Policy, Externalities, And Economic Growth

Externalities are a fundamental aspect of any modern interdependent economy. The fact that agents interact with one another makes it inevitable that their decisions will influence one another directly, in addition to any indirect impact that may occur through the market place. Ever since the earliest stages of the discipline, externalities have been of prime concern to economists, who have long argued that they provide an important motive for (economic) decision making. To cite one prominent example, in The Theory of Moral Sentiments, Adam Smith notes that “Though it is in order to supply the necessities and conveniences of the body that the advantages of external fortune are originally recommended to us, yet we cannot live long in the world without perceiving that the respect of our equals, our credit and rank in the society we live in, depend very much upon the degree in which we possess, or are supposed to possess those advantages. The desire of becoming the proper objects of this respect . . . is perhaps the strongest of all our desires” [Smith (1759, pp. 348–349)]. In modern terminology, Adam Smith is referring to a consumption externality.