Economic theory has generally acknowledged the role that institutions have in shaping economic space. The distinction, however, between physical and institutional descriptions of economic activity has not received adequate attention within the mainstream paradigm. In this paper I show how a proper distinction between the physical and institutional space in economic models will help clarify the concept of externality and provide a better interpretation of the relationship between externality and nonconvexity. I argue that within the Arrow-Debreu framework externality should be viewed as incongruence between the physical and institutional descriptions of the economic space. I also argue that, contrary to conventional wisdom, detrimental externality has no special association with nonconvexity. Starrett's (1972) fundamental nonconvexity has to do with the specific institutional structure of Arrow markets rather than the detrimental nature of externality. Indeed, Arrow markets may not eliminate externalities. In a similar vein, it is not detrimental externality, however intense, that causes the production possibility set to become nonconvex, as argued by Baumol and Bradford (1972), but the particular interpretation of intensity that would make even conventional production possibility sets nonconvex. These points become apparent when one distinguishes between the convexity of the physical and institutional production sets.
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