Social cost
Encyclopedia
Social cost, in economics
, is generally defined in opposition to "private cost". In economics, theorists model individual decision-making as measurement of costs and benefits. Rational choice theory
often assumes that individuals consider only the costs they themselves bear when making decisions, not the costs that may be borne by others.
With pure private goods, the costs carried by the individuals involved are the only economically meaningful costs. The choice to purchase a glass of lemonade
at a lemonade stand has little consequence for anyone other than the seller or the buyer. The costs involved in this economic activity are the costs of the lemons and the sugar and the water that are ingredients to the lemonade, the opportunity cost of the labour to combine them into lemonade, as well as any transaction costs, such as walking to the stand.
, then social costs will be greater than private costs. Environmental pollution is an example of a social cost that is seldom borne completely by the polluter, thereby creating a negative externality. If there is a positive externality, then one will have higher social benefits than private benefits. For example, when a supplier of educational services indirectly benefits society as a whole but only receives payment for the direct benefit received by the recipient of the education: the benefit to society of an educated populace is a positive externality. In either case, economists refer to this as market failure
because resources will be allocated inefficiently. In the case of negative externalities, private agents will engage in too much of the activity; in the case of positive externalities, they will engage in too little. (The marginal rate of transformation in production will not be equal to the marginal rate of substitution
in consumption due to the effect of the externality and as a result Pareto optimality will not occur—see welfare economics
for an explanation.)
are often used as an argument for government intervention in the form of regulations. Libertarians who believe in a free market
respond that the existence of market failure should not lead to government intervention. They prefer to rely on tradition
, community pressure, and dollar voting
.
Negative externalities (external costs) lead to an over-production of those goods that have a high social cost. For example, the logging of trees for timber may result in society losing a recreation area, shade, beauty, good quality soil to grow crops on, and air quality but this loss is usually not quantified and included in the price of the timber that is made from the trees. As a result, individual entities in the marketplace have no incentive to factor in these externalities. More of this activity is performed than would be if its cost had a true accounting.
This can be illustrated with a diagram. Profit-maximizing organizations will set output at Qp where marginal private costs (MPC) is equal to marginal revenue (MR). (This diagram assumes perfect competition
, under which price (P) equals MR.) This will yield a profit shown by the triangular area 0,C,F.
But if externalities are present, the attainment of social optimality requires that the full social costs must be considered. The socially optimum level of output is Qs where marginal social costs (MSC) is equal to marginal revenue (MR). The amount of output, Qp minus Qs, indicates the excess output due to the externality. Profits will decrease also, from 0,C,F to 0,A,F. It is clearly profitable for the firm to pollute, since "internalizing the externality" hurts profits. The amount of the externality will decrease from C,D to B,A.
Because the marginal social cost curve (MSC) is above the marginal private cost curve (MPC), this diagram illustrates the case of a negative externality. If the marginal social cost curve was below the marginal private cost curve, it would be a positive externality and social optimality would require a greater output than Qp rather than a reduction of output.
Institutional ecological economists in the tradition of Karl William Kapp
provide a different definition of social costs, i.e. that share of the total costs of production that is not born by producers but is shifted to 3rd parties, future generations or society at large. Kapp, hence, rejected Pigou's confusing terminology of externalities and provides several hundred pages of empirical data to support his argument that social costs are systemic, i.e. rooted in profit maximizing behavior of businesses, and an enormous problem of modern civilization. In the real world, they are usually not or cannot be internalized and must not be considered as accidental minor aberration from the "optimal norm" that can be fixed with ad hoc measures.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, is generally defined in opposition to "private cost". In economics, theorists model individual decision-making as measurement of costs and benefits. Rational choice theory
Rational choice theory
Rational choice theory, also known as choice theory or rational action theory, is a framework for understanding and often formally modeling social and economic behavior. It is the main theoretical paradigm in the currently-dominant school of microeconomics...
often assumes that individuals consider only the costs they themselves bear when making decisions, not the costs that may be borne by others.
With pure private goods, the costs carried by the individuals involved are the only economically meaningful costs. The choice to purchase a glass of lemonade
Lemonade
Lemonade is a lemon-flavored drink, typically made from lemons, water and sugar.The term can refer to three different types of beverage:...
at a lemonade stand has little consequence for anyone other than the seller or the buyer. The costs involved in this economic activity are the costs of the lemons and the sugar and the water that are ingredients to the lemonade, the opportunity cost of the labour to combine them into lemonade, as well as any transaction costs, such as walking to the stand.
Implications
If there is a negative externalityExternality
In economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
, then social costs will be greater than private costs. Environmental pollution is an example of a social cost that is seldom borne completely by the polluter, thereby creating a negative externality. If there is a positive externality, then one will have higher social benefits than private benefits. For example, when a supplier of educational services indirectly benefits society as a whole but only receives payment for the direct benefit received by the recipient of the education: the benefit to society of an educated populace is a positive externality. In either case, economists refer to this as market failure
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...
because resources will be allocated inefficiently. In the case of negative externalities, private agents will engage in too much of the activity; in the case of positive externalities, they will engage in too little. (The marginal rate of transformation in production will not be equal to the marginal rate of substitution
Marginal rate of substitution
In economics, the marginal rate of substitution is the rate at which a consumer is ready to give up one good in exchange for another good while maintaining the same level of utility.-Marginal rate of substitution as the slope of indifference curve:...
in consumption due to the effect of the externality and as a result Pareto optimality will not occur—see welfare economics
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...
for an explanation.)
Theory
The ideas of social cost, externalities, and market failureMarket failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...
are often used as an argument for government intervention in the form of regulations. Libertarians who believe in a free market
Free market
A free market is a competitive market where prices are determined by supply and demand. However, the term is also commonly used for markets in which economic intervention and regulation by the state is limited to tax collection, and enforcement of private ownership and contracts...
respond that the existence of market failure should not lead to government intervention. They prefer to rely on tradition
Tradition
A tradition is a ritual, belief or object passed down within a society, still maintained in the present, with origins in the past. Common examples include holidays or impractical but socially meaningful clothes , but the idea has also been applied to social norms such as greetings...
, community pressure, and dollar voting
Dollar voting
In economics, dollar voting is an analogy used to explain how the purchasing choices of consumers affect which products will continue to be produced and supplied to the market...
.
Negative externalities (external costs) lead to an over-production of those goods that have a high social cost. For example, the logging of trees for timber may result in society losing a recreation area, shade, beauty, good quality soil to grow crops on, and air quality but this loss is usually not quantified and included in the price of the timber that is made from the trees. As a result, individual entities in the marketplace have no incentive to factor in these externalities. More of this activity is performed than would be if its cost had a true accounting.
This can be illustrated with a diagram. Profit-maximizing organizations will set output at Qp where marginal private costs (MPC) is equal to marginal revenue (MR). (This diagram assumes perfect competition
Perfect competition
In economic theory, perfect competition describes markets such that no participants are large enough to have the market power to set the price of a homogeneous product. Because the conditions for perfect competition are strict, there are few if any perfectly competitive markets...
, under which price (P) equals MR.) This will yield a profit shown by the triangular area 0,C,F.
But if externalities are present, the attainment of social optimality requires that the full social costs must be considered. The socially optimum level of output is Qs where marginal social costs (MSC) is equal to marginal revenue (MR). The amount of output, Qp minus Qs, indicates the excess output due to the externality. Profits will decrease also, from 0,C,F to 0,A,F. It is clearly profitable for the firm to pollute, since "internalizing the externality" hurts profits. The amount of the externality will decrease from C,D to B,A.
Because the marginal social cost curve (MSC) is above the marginal private cost curve (MPC), this diagram illustrates the case of a negative externality. If the marginal social cost curve was below the marginal private cost curve, it would be a positive externality and social optimality would require a greater output than Qp rather than a reduction of output.
Institutional ecological economists in the tradition of Karl William Kapp
Karl William Kapp
Karl William Kapp was a German-American economist, one of the founders of Ecological economics and one of the leading 20th century institutional economists...
provide a different definition of social costs, i.e. that share of the total costs of production that is not born by producers but is shifted to 3rd parties, future generations or society at large. Kapp, hence, rejected Pigou's confusing terminology of externalities and provides several hundred pages of empirical data to support his argument that social costs are systemic, i.e. rooted in profit maximizing behavior of businesses, and an enormous problem of modern civilization. In the real world, they are usually not or cannot be internalized and must not be considered as accidental minor aberration from the "optimal norm" that can be fixed with ad hoc measures.
See also
- ExternalityExternalityIn economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit...
- Welfare economicsWelfare economicsWelfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...
- Environmental economicsEnvironmental economicsEnvironmental economics is a subfield of economics concerned with environmental issues. Quoting from the National Bureau of Economic Research Environmental Economics program:...
- List of economics topics