 Ask
Dr. Econ
November 2002
What is the difference between private and social costs, and how do
they relate to pollution and production?
This is an important distinction to understand. Private costs to firms
or individuals do not always equate with the total cost to society for
a product, service, or activity. The difference between private costs
and total costs to society of a product, service, or activity is called
an external cost; pollution is an external cost of many products. External
costs are directly associated with producing or delivering a good or service,
but they are costs that are not paid directly by the producer. When external
costs arise because environmental costs are not paid, market failures
and economic inefficiencies at the local, state, national, and even international
level may result.
Let's start by defining private costs, external costs, and social costs.
Next, we will briefly examine the impact external costs can have on prices,
production, resource allocation, and competition.
Key Concepts:
Private Costs + External Costs = Social Costs
If external costs > 0, then private costs < social costs.
Then society tends to:
- Price the good or service too low, and
- Produces or consumes too much of the good or service.
Different Costs Matter:
Private costs for a producer of a good, service, or activity
include the costs the firm pays to purchase capital equipment, hire labor,
and buy materials or other inputs. While this is straightforward from
the business side, it also is important to look at this issue from the
consumers' perspective. Field, in his 1997 text, Environmental Economics
provides an example of the private costs a consumer faces when driving
a car:
The private costs of this (driving a car) include the fuel and oil,
maintenance, depreciation, and even the drive time experienced by the
operator of the car.
Private costs are paid by the firm or consumer and must be included in
production and consumption decisions. In a competitive market, considering
only the private costs will lead to a socially efficient rate of output
only if there are no external costs.
External costs, on the other hand, are not reflected on
firms' income statements or in consumers' decisions. However, external
costs remain costs to society, regardless of who pays for them. Consider
a firm that attempts to save money by not installing water pollution control
equipment. Because of the firm's actions, cities located down river will
have to pay to clean the water before it is fit for drinking, the public
may find that recreational use of the river is restricted, and the fishing
industry may be harmed. When external costs like these exist, they must
be added to private costs to determine social costs and to ensure that
a socially efficient rate of output is generated.
Social costs include both the private costs and any other
external costs to society arising from the production or consumption of
a good or service. Social costs will differ from private costs, for example,
if a producer can avoid the cost of air pollution control equipment allowing
the firm's production to imposes costs (health or environmental degradation)
on other parties that are adversely affected by the air pollution. Remember
too, it is not just producers that may impose external costs on society.
Let's also view how consumers' actions also may have external costs using
Field's previous example on driving:
The social costs include all these private costs (fuel, oil, maintenance,
insurance, depreciation, and operator's driving time) and also the cost
experienced by people other than the operator who are exposed to the
congestion and air pollution resulting from the use of the car.
The key point is that even if a firm or individual avoids paying for
the external costs arising from their actions, the costs to society as
a whole (congestion, pollution, environmental clean up, visual degradation,
wildlife impacts, etc.) remain. Those external costs must be included
in the social costs to ensure that society operates at a socially efficient
rate of output.
Aside from the obvious environmental issues, one might ask why external
costs are of interest to economists?
Resource Implications
A socially efficient output rate in a competitive market is reached when
social costs (both private and external costs) are considered in production
and consumption decisions.
The existence of external costs has implications for product prices,
output levels, resource usage, and competition. When significant external
costs are associated with a good (or service), then the price of the good
is too low (because external costs are not being paid) and its output
level is too high, relative to the socially efficient rate of output for
the good. The bottom line, unless costs and prices include external costs,
the market will not produce a socially efficient result.
Consider also the competitive issues: At the individual firm level, as
well as across states or nations, failure to pay for external costs would
provide those firms or nations with a competitive advantage over producers
who are paying the external costs associated with the production of their
products. If you're interested, a graphic examination of the issue follows!
Here's the Graphic Illustration (for those who like charts!)
In the graphic illustration, the intersection of the demand curve and
marginal cost curve represents the socially efficient rate of output in
a competitive market. However, in the case where external costs exist,
we need to plot two curves: The marginal private cost curve and the marginal
social cost curve (equals the marginal private cost curve plus the marginal
external cost curve).
Comparing prices and outputs illustrates how external costs affect resource
allocation. If a firm (or nation) pays only the private costs and avoids
paying the external costs associated with their product, then output and
prices would be determined at point P where the marginal private cost
curve (heavy solid black line) meets the demand curve (thin purple line).
At P (thin dashed green lines) price equals Pp and output equals Op.
When private and external costs are paid by the firm, the marginal social
cost curve (dotted red line) is created by adding the marginal external
costs to the marginal private costs. In this case, the intersection of
the marginal social cost curve and the demand curve occurs at point S
(thin blue lines), with price Ps and output Os. Point S denotes the socially
efficient rate of production.
From a resource standpoint, the important point of this comparison is
that including the marginal external costs of production and allocating
resources based on the full social cost results in a higher price for
the good (Ps > Pp) and less output (Os < Op) than only including
the private costs. Lower output typically would also reduce the amount
of pollution generated by the activity.
Summary
Society is better off when production and consumption decisions are based
on social costs that include external costs, because external costs really
do matter in the real world. Policy makers look for ways to make firms
and consumers 'internalize' or take into account the external costs they
create when they make production and consumption decisions.
Endnotes:
- Field. 1997. Environmental Economics: An Introduction,
page 52.
- Field. 1997. Environmental Economics: An Introduction,
page 52.
- Ibid. Chapter 4, Economic Efficiency and Markets,
pages 63-73.
Resources
Field, Barry C., 1997. Environmental Economics: An Introduction.
Irwin/McGraw-Hill, Boston.
Johnson, Harry G. 1990 reprint. Man and
His Environment. Occasional Paper No. 6, British-North American Committee.
Some Web site suggestions:
Environmental
Literacy Council.
http://www.enviroliteracy.org/category.php/5.html
Environmental
Protection Agency (EPA) Educational Resources.
http://www.epa.gov/epahome/educational.htm
World
Bank: Environmental Economics and Indicators.
http://lnweb18.worldbank.org/ESSD/essdext.nsf/44ParentDoc/EnvironmentalEconomicsandIndicators?Opendocument
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