Externalities
can cause market failure if the price mechanism does not take into account
the full social costs and social benefits of production and consumption. The
study of externalities by economists has become extensive in recent years -
not least because of concerns about the link between the economy and the
environment.
Externalities create a divergence
between the private and social costs of production.
Social cost includes all the costs of production of the output of a
particular good or service. We include the third party (external) costs
arising, for example, from pollution of the atmosphere.
SOCIAL COST = PRIVATE COST +
EXTERNALITY
For example: - a chemical factory emits wastage as a by-product into
nearby rivers and into the atmosphere. This creates negative externalities
which impose higher social costs on other firms and consumers. e.g. clean up
costs and health costs.
Another
example of higher social costs comes from the problems caused by traffic
congestion in towns, cities and on major roads and motor ways. It is
important to note though that the manufacture, purchase and use of private
cars can also generate external benefits to society. This why cost-benefit analysis can be useful in measuring and putting some
monetary value on both the social costs and benefits of production.
