What’s it: Social cost is private cost plus external cost. Private cost is borne by individuals directly involved in economic transactions or activities. Meanwhile, the external cost is borne by third parties not directly involved in the transaction.
The social cost is the opposite of social benefit, representing the benefits that businesses and households receive from their production or consumption activities. It equals private benefits plus external benefits.
Social cost components
In neoclassical economics, social costs consist of:
- Private costs
- External costs
The total social cost is equal to the sum of the two. If we write it down mathematically, the social cost formula is as follows:
Social cost = Private cost + External cost
Under perfectly competitive markets, the output would be socially efficient if it consisted only of private costs. There are no external costs.
Private costs represent costs borne by economic actors, which influence their economic decisions. Neoclassical economics assumes no government intervention. Thus, economic actors only consist of businesses and households (consumers), where the main economic activities and decisions of both are about production and consumption.
In production, private costs include costs for the production of goods or services. They cover spending on capital equipment, hiring labor, and buying materials or other inputs.
Thus, private costs influence decisions on the production of goods and services by the business sector. Also, these costs form the selling price of the product, in addition to the profit percentage (markup) they charge.
For consumption, private costs represent the price paid by consumers for goods and services. When you buy cold medicine, you pay the price, which is the price of cold medicine.
External costs are not reflected in the company’s production costs. You won’t see it on the company’s income statement. Likewise, it is also not reflected in the price borne by consumers. Nonetheless, external costs remain costs to society, regardless of who pays them.
For example, a textile company might try to save money. They then did not install water pollution control equipment or factory waste. Due to the company’s actions, cities located downstream of the river have to pay for the adverse effects of waste or pollution. River water becomes unfit for drinking. To fulfill their drinking needs, they have to buy clean water.
Long story short, external costs represent costs arising from negative externalities. Economic actors who are not involved in economic activities must bear the impact directly. In the above case, they are the people around the river. They may not work for a textile company. However, due to water pollution, they have to spend money to buy clean water, which does not come from the company. Other examples of external costs are noise, congestion, and visual disturbances.
Ideally, external costs should be added to private costs to determine social costs. It is essential to produce a socially efficient level of output.
Social cost effects
Under a competitive market, the market output will be efficient if production (supply) and consumption (demand) decisions consider social costs. Market prices represent production costs and external costs, which are not borne by the transacting parties. Besides, social costs also have an impact on market output, competition, and resource use.
Say, the external costs associated with production (e.g., the impact of waste) are significant. Companies do not pay for it, for example, through taxes or by buying waste processing machines. In this case, the goods’ selling price is lower than it should be because it does not take external costs into account.
At this level of production, the output may be efficient for the firm. However, it is socially inefficient. The consumer of the product may benefit from the lower price. However, other communities, who do not consume, have to bear the costs of the waste.
Without government intervention, littering may become a common practice for businesses. This practice saves money because there is no need to treat waste.
That is one of the most common reasons why governments should step in. The government then formulates policies to correct externalities. Without government intervention, businesses will pursue their own profits by ignoring their production activities’ negative externalities. It also applies to negative externalities resulting from the consumption of goods.
However, questions and problems then arise, how to quantify these social costs? The impact on environmental, socio-economic, or political damage is difficult to measure, especially in the long term. Also, negative externalities have an impact not only on the domestic market but also on the international market. A good example is the impact of carbon emissions on global warming.