Social Costs

Social and Private Costs Differences: An Example

Let's say that you enjoy listening to loud music. You turn up the speaker volume to the maximum - what is the private cost to you? Well, maybe the batteries in your speaker will run out a bit sooner; or if your speaker is plugged in, you pay a tiny bit more in electricity charges. Either way, this will be a small cost to you. Also, you know that listening to loud music is not that good for your hearing, but you are still young, so you don't really care about that and don't even hesitate a little bit before you reach to turn up the volume.

Imagine that you have a neighbor who lives in the apartment next door and would like to relax at home. The soundproofing between your two apartments is not that good, and he can hear your loud music very well next door. The disturbance that your loud music causes to your neighbor's well-being is an external cost - you don't bear this disturbance yourself, and you are not compensating your neighbor for it.

The social cost is the sum of the private cost and the external cost. In this situation, the social cost of playing your loud music is the extra battery or electricity cost, the damage to your hearing, plus the disturbance to your neighbor.

Marginal Social Cost

Economics is about making decisions at the margin. So with regard to social costs, economists use the measure of marginal social cost to decide the socially optimal level of an activity.

In situations where there are negative externalities, the marginal social cost would be higher than the marginal private cost: $MSC>MPC$. A classic example of this is a polluting firm. Let's say there is a factory that pumps heavily polluted air in its production process. Residents in the surrounding area have to suffer lung problems as a result of the firm's activity. The additional damage to the residents' lungs for each additional unit that the factory produces is the marginal external cost. Because the factory doesn't take this into account and only considers its own marginal private cost in deciding how many goods to produce, it will result in over-production and social welfare loss.

Figure 1 shows the case of the polluting factory. Its supply curve is given by its marginal private cost (MPC) curve. We are assuming that there is no external benefit to its production activity, so the marginal social benefit (MSB) curve is the same as the marginal private benefit (MPB) curve. To maximize profit, it produces a quantity of Q1 where marginal private benefit (MPB) equals marginal private cost (MPC). But the socially optimal quantity is where marginal social benefit (MSB) equals marginal social cost (MSC) at the quantity of Q2. The triangle in red represents the social welfare loss from over-production.

Fig. 1 - Marginal social cost is higher than the marginal private cost

Social Costs: Why Do External Costs Exist?

Why do externalities exist in the first place? Why can't the free market just take care of it and find the optimal solution for everyone involved? Well, there are two reasons that prevent the free market from reaching the socially optimal outcome: the lack of well-defined property rights and the existence of high transaction costs.

Lack of well-defined property rights

Imagine if someone hits your car in an accident. The other person would have to pay for the damage to your car if it's their fault. The property rights here are well-defined: you clearly own your car. Someone has to compensate you for damages they cause to your car.

But when it comes to public resources or public goods, the property rights are way less clear. Clean air is a public good - everyone has to breathe, and everyone is affected by the air quality. But legally, the property rights involved are not so clear. The law doesn't explicitly say that everyone has partial ownership of the air. When a factory pollutes the air, it is not always easy legally for someone to sue the factory and demand compensation.

High transaction costs

A the same time, the consumption of a public good such as clean air involves a lot of people. The transaction costs can be so high that it effectively prevents a resolution between all the parties involved.

High transaction costs are a very real problem for the market to find a resolution in the case of pollution. There are simply too many parties involved. Imagine that even if the law allows you to sue the polluters for worsening air quality, it would still be nearly impossible for you to do so. There are countless factories that are polluting the air in a region, not to mention all the vehicles on the road. It would be impossible to even identify all of them, let alone to ask all of them for monetary compensation.

Fig. 2 - It would be very difficult for an individual to ask all car drivers to compensate for the pollution that they cause

Social Costs: Examples of External Costs

Where can we find examples of external costs? Well, external costs are everywhere in everyday life. Every time when someone or some firm imposes some harm on others without compensating for it, that's an external cost. Examples include when someone is being loud and disturbs their neighbors; when a roommate leaves dirty dishes in the sink; and the noise and air pollution from vehicle traffic. In all of these examples, the social costs of the activities are higher than the private costs to the person doing the action because of the external costs that these actions impose on other people.

The social cost of carbon

With the serious consequences of climate change, we are paying more and more attention to the external cost of carbon emissions. Many countries around the world are thinking of ways to properly account for this external cost. There are two main ways to make firms internalize the cost of carbon emissions in their production decisions - through a tax on carbon or a cap-and-trade system for carbon emissions permits. An optimal carbon tax should be equal to the social cost of carbon, and in a cap-and-trade system, the optimal target price should be equal to the social cost of carbon as well.

The question then becomes: what exactly is the social cost of carbon? Well, the answer is not always straightforward. The estimation of the social cost of carbon is a highly contested analysis both because of the scientific challenges and also the underlying socioeconomic implications.

For instance, during the Obama Administration, the U.S Environmental Protection Agency (EPA) estimated the social cost of carbon and came up with a value of approximately $45 per ton of CO2 emissions in 2020, using a 3% discount rate. However, the cost of carbon was changed to $1 - $6 per ton under the Trump administration, using a 7% discount rate.¹ When the government uses a higher discount rate to calculate the cost of carbon, it discounts the future damage of carbon emissions more, therefore it will get to a lower present value of the cost of carbon.