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.
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?
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.
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.
1. Field. 1997. Environmental Economics: An Introduction, page 52.
2. Field. 1997. Environmental Economics: An Introduction, page 52.
Ibid. Chapter 4, Economic Efficiency and Markets, pages 63-73.
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.
Environmental Protection Agency (EPA) Educational Resources.
World Bank: Environmental Economics and Indicators. http://lnweb18.worldbank.org/ESSD/essdext.nsf/44ParentDoc/EnvironmentalEconomicsandIndicators?Opendocument