Question

What is the difference between private and social costs? How does this relate to pollution and production?

Answer 1

Solution:

Private costs to firms or individuals do not always equate with the total cost to society for a product, service, or activity. The difference between private costs and total costs to society of a product, service, or activity is called an external cost; pollution is an external cost of many products. External costs are directly associated with producing or delivering a good or service, but they are costs that are not paid directly by the producer. When external costs arise because environmental costs are not paid, market failures and economic inefficiencies at the local, state, national, and even international level may result.

Private Costs + External Costs = Social Costs

If external costs > 0, then private costs < social costs.

Then society tends to:

- Price the good or service too low, and

- Produces or consumes too much of the good or service.

Private costs for a producer of a good, service, or activity include the costs the firm pays to purchase capital equipment, hire labor, and buy materials or other inputs.

External costs, on the other hand, are not reflected on firms' income statements or in consumers' decisions. However, external costs remain costs to society, regardless of who pays for them.

The social costs include all these private costs (fuel, oil, maintenance, insurance, depreciation, and operator's driving time) and also the cost experienced by people other than the operator who are exposed to the congestion and air pollution resulting from the use of the car.

The existence of external costs has implications for product prices, output levels, resource usage, and competition. When significant external costs are associated with a good (or service), then the price of the good is too low (because external costs are not being paid) and its output level is too high, relative to the socially efficient rate of output for the good. The bottom line, unless costs and prices include external costs, the market will not produce a socially efficient result.