External Effects and Cost of Production

Recent studies (Romer, 1986; Lucas, 1988) have stressed the importance of factors external to the firm in the production process. Such externalities are assumed to have a direct effect on the level of production or to enhance the productivity of traditional inputs. Broadly speaking, we can identify two types of externalities. First, inputs that are not explicitly taken into account in the firm’s decision-making process although they contribute to the production process (for instance, the availability of human capital, public capital or infrastructure, and social capital). We will refer to these external effects as “external inputs.” Second, externalities that are relevant outside the economies giving rise to the externality, regardless whether these economies are understood as the economy of a specific industry or a specific country or region. This type of externality has recently been considered theoretically in growth models dealing with open economies.