Social cost

In neoclassical economics social cost is defined as the sum of private and external costs. Neoclassical economic theorists ascribe individual decision-making to a calculation costs and benefits. Rational choice theory assumes that individuals only consider their own private costs when making decisions, not the costs that may be borne by others. 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.

Implications

If there is a negative externality, 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 externalites, 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.)

Theory

The ideas of social cost and externalities are often used in Keynesian economics as an example of market failure and 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, 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 Q_p 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 Q_s where marginal social costs (MSC) is equal to marginal revenue (MR). The amount of output, Q_p minus Q_s, 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 Q_p rather than a reduction of output.

Pigovian taxes

Because the market mechanism fails to factor in the total cost to society,^{[citation needed]} output decisions are flawed, resources are allocated inefficiently, and social welfare is reduced. One method of reducing the effect of this market failure is to impose a Pigovian tax equal to the amount of the negative externality (or impose a subsidy in the case of a positive externality).

See also

• Externality
• Welfare economics
• Environmental economics
• List of economics topics