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Social cost in neoclassical economics is the sum of the private costs resulting from a transaction and the costs imposed on the consumers as a consequence of being exposed to the transaction for which they are not compensated or charged. "Federal Reserve Bank of San Francisco" In other words, it is the sum of private and . This might be applied to any number of economic problems: for example, social cost of carbon has been explored to better understand the costs of carbon emissions for proposed economic solutions such as a carbon tax.
Private costs refer to direct costs to the producer for producing the good or service. Social cost includes these private costs and the additional costs (or external costs) associated with the production of the good which are not accounted for by the free market. In short, when the consequences of an action cannot be taken by the initiator, we will have external costs in the society. We will have private costs when initiator can take responsibility for agent's action.de V. Graaff J. (1987). "Social Cost". In: The New Palgrave Dictionary of Economics. Palgrave Macmillan, London.
Social costs can be of two types—Negative Production Externality and Positive Production Externality. Negative Production Externality refers to a situation in which marginal damages are social costs to society that result in Marginal Social Cost being greater than the Marginal Private Cost i.e. MSC > MPC. Intuitively, this refers to a situation in which the production of the firm reduces the well-being of the people in the society who are not compensated for the same. For example, steel production results in a negative externality because of the marginal damages pertaining to pollution and negative environmental effects. Steelmaking results in indirect costs as a result of emission of pollutants, lower air quality, etc. For example, these indirect costs might include the health of a homeowner near the production unit and higher healthcare costs which have not been factored into the free market price and quantity. Given that the producer does not bear the burden of these costs, they are not passed down to the end user thus creating a situation where MSC > MPC.
This example can be better elucidated with a diagram. Profit-maximizing organizations in a free market will set output at QMarket where marginal private costs (MPC) is equal to marginal benefit (MB). Intuitively, this is the point on the diagram where the private supply curve (MPC) and consumer demand curve (MB) intersect i.e. where consumer demand meets firm supply. This results in a competitive market equilibrium price of pMarket.
In the presence of a negative production externality, the private marginal cost increases i.e. shifted upwards to the left by marginal damages to yield the marginal social curve. The star in the diagram, or the point where the new supply curve (inclusive of marginal damages to society) and the consumer demand intersect, represents the socially optimum quantity Qoptimum and price. At this social optimum, the price paid by the consumer is p*consumer and the price received by the producers is p*producer.
High positive social costs, in the form of marginal damages, lead to an over-production. In the diagram, there is overproduction at QMarket - Qoptimum with an associated deadweight loss of the shaded triangle. One of the public sector remedies for internalizing externalities is a corrective tax. According to neoclassical economist Arthur Pigou,Pigou, Arthur C., 1920, The Economics of Welfare (London: Macmillan). in order to correct this market failure (or externality) the government should levy a tax which equals to marginal damages per unit. This would effectively increase the firm's private marginal so that SMC = PMC.
The prospect of government intervention in regards to correcting an externality has been hotly debated. Economists like Ronald CoaseCoase, Ronald, 1960, "The Problem of Social Cost", Journal of Law and Economics, Vol. 3, No. 1, pp. 1–44 contend that the market can internalize an externality and provide for an external outcome through bargaining among affected parties. For example, in the above-mentioned case, the homeowners could negotiate with the pollution firm and strike a deal in which they would pay the firm not to pollute or to charge the firm for pollution; the outcome pertaining to who pays is determined by bargaining power. According to Thomas Helbing at the International Monetary Fund, government intervention might be most optimal in situations where one party might have undue bargaining power compared to the other party.
In an alternative scenario, positive production externality occurs when the social costs of production are lower than the marginal private costs of production. For example, the social benefit of research and development not only applies to the profits made by the firm but also helps improve the health of society through better quality of life, lower healthcare costs, etc. In this case, the marginal social cost curve would shift downwards and there would be underproduction. In this case, government intervention would result in a Pigouvian subsidy in order to decrease the firm's private marginal cost so that MPC = SMC.
Another example concerning the difficulty surrounding the estimation of social costs is the social cost of carbon. In trying to monetize the social costs arising from carbon, one needs to understand "the effect of a ton of a greenhouse gas on global temperatures, the effect of temperature change on agricultural yields, human health, flood risk, and myriad other harms to the ecosystem". "The social costs of carbon", Brookings Institution. Analysts from Brookings Institution contend that one of the reasons the estimation of the social cost of carbon is incredibly complex is that the external costs imposed on society as a result of the transactions of one firm in China, for example, impact the quality of lives and health of consumers living in the United States.
Social costs are also linked with the analysis of market failure. Take the national dividend, for example; to maximize the national dividend, it is required that one set marginal social costs and marginal social benefits equal to each other. Marginal private costs and marginal private benefits also need to be equal to each other to maximize market behaviors. However, the market will not be maximized without both sets of costs and benefits equal to each other.
Applications
Social cost has been applied on a number of different critical social issues. Notably the social cost of carbon and monopolies are common topics of exploration.
Carbon
See also
Further reading
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