The term external cost or externality is used to define the costs that arise from any human activity when the agent responsible for the activity does not take full account of the impacts on others of his or her actions. Equally, when the impacts are positive and not accounted for in the actions of the agent responsible they are referred to as external benefits. Consider first the following example of external costs. Emissions of particulate pollution from a power station affect the health of people in the vicinity, but this is not often considered, or is given inadequate weight in private decision-making, as there is no market for such impacts. Such a phenomenon is referred to as an externality, and the costs it imposes are referred to as the external costs.
External costs are distinct from the costs that the emitters of the particulates take into account when determining their outputs, costs such as the prices of fuel, labour, transportation, and energy. Categories of costs that influence an individuals decision-making are referred to as private costs. The total cost to society is made up of both the external cost and the private cost, which together are defined as social cost:
Social Cost = External Cost + Private Cost
The private cost component is generally taken from the market prices of the inputs. Thus, if a project involves an investment of US$5 million, as estimated by the inputs of land, materials, labour and equipment, that figure is used as the private cost. That may not be the full cost, however, as far as the estimation of social cost is concerned. If, for example, the labour input is being paid more than its value in alternative employment, the private cost is higher than the social cost. Adjustments to private costs based on market prices to bring them into line with social costs are referred to as shadow pricing. A fuller discussion of shadow pricing is given in Ray (1984).
External costs typically arise when markets fail to provide a link between
the person who creates the externality and the person who is affected
by it, or more generally when property rights for the relevant resources are
not well defined. If such rights were defined, market forces and/or bargaining
arrangements would ensure that the benefits and costs of generating the external
effect balanced properly. The failure to take into account external costs, however,
may be a product not only of a lack of property rights, but also the result
of a lack of full information and non-zero transaction costs.
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