An external cost or negative externality is a cost that a transaction or activity imposes on a party that is not part of the transaction or activity. In other words, it is a cost imposed on a party that cannot control whether or not the transaction or activity occurs.
The complementary notion is that of external benefit or positive externality.
The social cost of an activity is usually defined as the sum of the private cost (i.e., the total cost to those directly participating in the acitivity) and the external cost.
Problems with external costs
Inefficiency and market failure
External costs could in principle lead to a market failure -- when certain transactions or activities occur even when the external costs of those activities exceed the benefits. Note that the presence of external costs does not result in market failure if the external cost is less than the benefit from the activity.
Even in situations where activities are efficient despite external costs, they may still be considered unfair, because the people on whom the external costs are imposed are forced to pay these costs despite having no say in whether or not the activity should happen.
The concept of missing markets and transaction costs
An external cost that is not adequately dealt with by the market is often thought of as a missing market -- hence the saying externalities are missing markets. In other words, allowing the external parties affected to enter market negotiations with those parties carrying out the transaction could often resolve the problem of external costs.
The Coase theorem, proved by Ronald H. Coase, states that if people can compensate each other for external costs/benefits, and if transaction costs are zero, then bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. Note that the Coase theorem highlights that the main reason for market failure is not the external costs themselves, but the transaction costs involved in negotiation. These transaction costs may be due to lack of trust, inability to enforce contracts, or a large number of parties involved.
Fairness and legal rights
While the Coase theorem states that in the absence of transaction costs, the outcome will be efficient regardless of the initial allocation of property rights, it does not say that the outcome will be fair. However, a stronger version of the theorem states that for every possible efficient outcome, there is an allocation of property rights under which, in the absence of transaction costs, bargaining will lead to that efficient outcome.
A Pigouvian tax is a tax imposed on a transaction or activity so as to capture the external costs of that activity. In the presence of a Pigouvian tax, a person will engage in the activity only if the net private benefit exceeds the external cost. However, for a Pigouvian tax to be fair, the tax revenue must be used to compensate the people who suffer the external cost.
The analogous notion for external benefits is that of a Pigouvian subsidy.
Expository book references
- The Undercover Economist by Tim Harford, 10-digit ISBN 0345494016, 13-digit ISBN 978-0345494016 (paperback)More info, Page 80-104, Chapter 4 (Crosstown Traffic)
- Naked Economics: Undressing the Dismal Science by Charles Wheelan, 10-digit ISBN 0393324869, 13-digit ISBN 978-0393324860More info, Page 44-51, Chapter 3 (Government is your friend (and a round of applause for all those lawyers))