Externality

In a general sense, a technological externality is the indirect effect of a consumption activity or a production activity on the consumption or production possibilities available to some other consumer or producer. By the term indirect it is meant that the effect concerns an agent other than the one exerting this economic activity and that this effect does not work through the price system. This effect has first been analyzed by Pigou (1920).

In a non-cooperative game, the utility payoff to one player usually only depends on the profile of strategies taken by all the players, but not on the identity of the players that undertake certain actions or that face certain outcomes. If this is the case, the game is said to contain externalities. In an auction with externalities, for example, the final valuation for the object in sale of each bidder depends on the identity of the player who wins the auction and receives the object. The modification of payoffs due to externalities in a game can be thought of as an immediate consequence of the actions taken during the play of the game, as in production externalities, or as a reduced-form description of expected future interactions among the players (i.e., their equilibrium behavior) after the end of the game, as in the case of an auction with resale possibilities of the object obtained.

Literature: Pigou (1920), Laffont (1987)

Entry by: Aner Sela and Joachim Winter

November 10, 1997
Direct questions and comments to: Glossary master