Social Costs

The term social cost refers to the larger effects on society of externalities created through productive economic activity. The theory of social cost attempts to analyze the total cost of economic activity, including not only the cost to those directly involved in the transaction but also to society as a whole. It attempts to allocate responsibility for harm caused by economic activity among the various parties affected. This theory has application across a broad spectrum of economic activities, but it is particularly important in evaluating the environmental impact of certain kinds of production. By attempting to assess the effects of externalities on the surrounding community, it seeks to determine how best to account for and correct for those externalities, with the goal of minimizing the overall harm caused by production.

A common example involves two industries that use the same area, such as a fishery and a factory situated adjacent to one another. The fishery relies on clean water to raise its fish, while the factory uses the lake to dump polluting chemicals. By dumping into the lake, the factory causes harm to the fishery, thus imposing a cost on agents who are not involved in its production process. Social cost theory seeks to determine what kind of compensation, if any, is owed to the fishery by the factory.

One possible approach would be to require that the factory, as the polluter, bear the cost of cleaning up the damage caused by its pollution, restoring the lake as much as possible to a pristine condition. To do so, however, would be to impose a cost on the factory in the name of the fishery, thus making the factory liable for the fishery's loss. Alternatively, the factory may choose to install pollution filters that would prevent the lake from becoming contaminated, but this would still impose a cost on the factory for the sake of ameliorating a cost to the fishery.

Another approach would involve government regulation of the polluting industry to reduce the externalities and the attendant harm to others. This could be done in a number of ways. Government might come in as a neutral arbitrator among the various parties to balance the relative costs and benefits of the various options available. Alternatively, it might require the polluting industry to install the filters that it might otherwise have found to be too costly. It could also choose to levy a fee on the industry—requiring it to pay according to the amount of damage done. In theory, this governmental intervention will allocate responsibility on the basis of the source of the pollution. The most well-known approach to this strategy is a “Pigou tax” (named after British economist Arthur C. Pigou, who developed the idea in which fees are levied on a perunit basis according to the cost of the pollution, with the goal of “internalizing” the costs of the externalities, creating an incentive for industry to create fewer polluting emissions). In practice, such governmental interventions are often less than optimally efficient and are looked at askance by many economists, particularly those of the more libertarian persuasion.

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