This post talks about costs and benefits – both private costs and social costs, as well as private benefits and social benefits. It also defines the term externalities and explains that externalities are created when social costs and benefits differ from private costs and benefits.
Additionally, it describes how the greater the externality the greater the market failure.
Costs – Private Costs and Social Costs
A private cost is the cost of an activity to an individual, such as a company or consumer. These costs could include materials, labor and land. For example, an individual who owns a car has the private costs associated with car ownership. This could include petrol, insurance, oil, water, TAX, safety checks and of course the cost of purchasing the car. Or, a company that owns a factory has private costs associated with its operation. This could include salaries, materials and other supplies, energy costs and TAX.
A social cost is the cost of an activity to not only the individual but the whole of society. Therefore, it includes private costs and all other costs. Additional social costs may include pollution and a worsening of the environment. For example, when an individual pays for their car, it does not include the cost of damaging the environment. Or, a company which manufactures products pays for the operation of the business but not for pollution that is produced.
In both of the above examples pollution is a cost to society. It is a price we all pay for the activities of an individual economic agent.
Benefits – Private Benefits and Social Benefits
A private benefit is a benefit produced by an activity to an individual. For example, an individual who owns a car has benefits because a car is convenient and allows more freedom. Or, a company which owns a factory in an industrial zone may benefit from special TAX treatment from the government. Alternatively they could benefit from skilled and experienced labor which exists near that special location. Of course, the benefit of conducting business is profit; these benefits belong to the owners of the company and they alone benefit.
A social benefit is that which benefits the whole of society, not just the user. Therefore, it includes private benefits and all other benefits. For example, the car owner is spending money in the economy, creating demand and work for others. Or, the factory employs people and puts money into the local and national economy.
Remember, when an individual or group is affected in a beneficial way because of the action of another economic agent, society benefits from a ‘positive externality’.
What are externalities?
Externalities arise when social costs and benefits are different from private costs and benefits. There are two types of externality, positive and negative.
A. Positive externalities. When social benefits are greater than private benefits then a positive externality is said to exist. An example could be a company setting up in an area of high unemployment. The company may have been attracted by the abundance of cheap labor or perhaps by government incentives such as low rent or TAX. These things are the private benefits for the firm; however, there are many social benefits resulting from this investment. Income will increase for local people, the quality of life will improve and other businesses will be encouraged to open. All of these social benefits are revitalizing the local economy, which in turn generates more TAX revenue for the government.
B. Negative externalities. When social costs are greater than private costs then a negative externality is said to exist. If for instance a motorway was to be built next to an apartment block, the owners of the homes could pay for double-glazed windows to reduce the excess noise interfering with their lives. They may need to paint their home more often because of damage from pollution. These costs are not included in the cost of building the motorway. They are negative externalities.
Externalities exist when social costs and benefits are greater than private costs and benefits. Those which benefit society are called ‘positive externalities’, while those which are a cost are called ‘negative externalities’.
