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In most cases, the costs borne 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 labor to combine them into lemonade, as well as any transaction costs, such as walking to the stand. Since these two individuals are involved in the economic transaction and are the only ones involved in the transaction, all the costs and benefits can be said to be "internal" to the economic transaction. In this case, the social cost is the same as the private cost. In some cases, there are costs or benefits incurred on parties not involved in the economic exchange. If someone decides to light and smoke a cigarette, for example, they incur costs, namely increased health risk and the cost of one cigarette. The smoker also gains benefits: the enjoyment of the cigarette. Other individuals around the smoker may also suffer costs or enjoy benefits. Some people like the smell of cigarette smoke. Others may detest it. Everyone around the smoker is put at some higher risk of health problems. The individual making the economic choice, in this case, is the smoker. In this case, unlike the lemonade case, there are costs and benefits that are incurred on agents outside the economic transaction--costs and benefits "external" to the economic activity. These costs and benefits are known as Externalities . Social cost incorporates the total of all the Cost s associated with an economic activity. It includes both costs borne by the economic agent and also all costs borne by society at large. It includes the costs reflected in the organization's Production Function (called Private Cost s) and the costs external to the firm's private costs (called Negative Externalities Or External Costs ). 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''. Since private costs are incorporated in the social costs the social costs can not be less than the private costs. An example is 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.) 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, instead preferring reliance 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 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. PIGOVIAN TAXES See Also: Pigovian tax Because the market mechanism fails to factor in the total cost to society, 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 |
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