World Development, Vol. 19, No. 6, pp. 569-594, 1991. 0305-750X/91 $3.00 + 0.00 Printed in Great Britain. Pergamon Press plc How Significant Are Externalities for Development? FRANCES STEWART AND EJAZ GHANI* Universityof Oxford Summary. -- This paper provides an assessment of the magnitude and policy significance of externalities in developing countries. Much past analysis has focused on static externalities. The analytic survey of concepts and evidence, however, suggests that dynamic externalities are of major significance -- in particular the nonmarket transmission of technological innovation and the cumulative interaction of learning economies, scale economies, innovation and market growth. Examples of the history of the semiconductor industry in the United States and agroindustrial development in the Punjab illustrate. Policy implications include protection and subsidization of industries particularly subject to this process. If one man starts a new idea, it is taken up by others and combined with suggestions of their own; and thus it becomes the source of further new ideas. And presently subsidiary trades grow up in the neighbourhood, supplying it with implements and materials . . . (Marshall 19211, p. 225). Here is not just another exception to the doctrine of free trade. What is involved is the problem of a structural change in the pattern of specialisation which may be all too important in the early stages of economic development (Bardhan, 1973, p. 455). 1. INTRODUCTION Externalities occur where market-priced trans- actions do not fully incorporate all the benefits and costs associated with transactions between economic agents. Externalities thus constitute market failures• Their presence means that the unregulated price system does not result in a social optimum, and consequently provides a prima facie reason for government intervention.I Pigou defined an externality as occurring in a situation where • . . one person, A, in the course of rendering some service, for which payment is made, to a second person B, incidentally also renders services or disservices to other persons (not producers of like services) of such a sort that payment cannot be exacted from the benefitted parties or compensa- tion enforced on behalf of the injured parties (Pigou, 1938, p. 183). Linkages describe all transactions between economic agents, whether through the market or outside it, fully or partially priced. Consequently, externalities are a subset of linkages. The linkage approach, however, provides useful insights: the conceptualization of linkages, and in particular the breakdown into different types of linkage, suggests a similar classification of externalities, while the empirical work on linkages, although evidently capturing a much larger range of transactions than externalities alone, points to the areas where externalities may be found, since the existence of linkages is generally a precondi- tion for the existence of externalities. 2 Spillover is a rather loosely defined concept, which is sometimes used to mean the same as linkages, sometimes externalities. We will not use the term. The significance attributed to externalities in development thinking has gone in waves. Initially, it seemed that the type of externalities typically referred to in the economic literature -- for example, bees and orchards or laundries and smoke-creating factories -- were relatively unim- portant in the context of development and could *This paper was written for a World Institutc for Development Economics Research (WIDER) project. We are grateful to WIDER for permission to publish it here. We have greatly benefitted from comments on earlier versions of this paper t'ronl Paul Anand, G. K. Hclleiner, participants at the WIDER mceting "'New Trade Theories and lndustrialisation in Developing Countries", August 1988, and participants at an Oxford seminar. 569