1.1.6 - External costs, benefits and social outcomes

Private and external costs

The costs paid by the person or firm making a decision may leave out costs imposed on other people.

Private costs are borne by the people directly involved in an activity. A delivery company pays for fuel, vehicles and drivers; these costs enter its decision. External costs are adverse effects imposed on third parties who are not directly part of the transaction and are not compensated through that transaction. They are also called negative externalities.

For pollution, a factory may pay its own energy bill while nearby residents bear health problems or cleaning costs from its smoke. For congestion, a driver considers their own fuel and travel time, but an extra car can delay other road users. The delay imposed on others is external; the driver’s own time is a private cost. For environmental damage, clearing a habitat for extraction may reduce wildlife or recreational enjoyment for others without the producer paying for all that loss.

The same activity can have both private and external costs, and counting them requires a clear boundary. If a company compensates a resident for a loss already included in private costs, do not add that same loss again as uncompensated external cost. Money changing hands is not itself new resource damage. Some external costs, such as lost habitat, are difficult to value in currency, but difficulty measuring them does not mean they are zero.

Ignoring external costs can encourage more activity than is desirable when all social costs are considered. This gives an economic reason to consider intervention, but does not identify the best policy without further information.

Private and external benefits

Some activities benefit other people as well as the individual who chooses them.

Private benefits accrue to those directly involved. A student may gain knowledge, enjoyment and higher future earnings from study. External benefits are favourable effects on third parties outside the transaction, for which the decision-maker is not paid through that transaction. These positive externalities can mean that private demand understates the whole social gain.

Education can benefit employers, colleagues and wider society through skills shared with others and more informed decisions. The student’s own higher earnings are a private benefit; an improvement enjoyed by others is external. Not every benefit of education is therefore an externality.

Healthcare can improve an individual patient’s health, a private benefit. Effective treatment of an infectious illness can also reduce transmission to other people, an external benefit. Better health may reduce disruption experienced by colleagues or family members. Identify the particular third-party gain rather than describing every treatment as automatically producing the same external effect.