Social cost and social benefit constitute two parts of one phenomenon. They reflect the effect of an economic activity of someone (producer or consumer) on the economic position of someone else who is not directly involved in that activity. Any individual economic decision, and its resulting activity, implies cost in terms of an opportunity foregone, such as opportunity cost. For instance, the labor used for the production of “x” excludes its use for the production of “y.” If the activity causes cost to a third party, this cost must be added to the privately borne opportunity cost. An activity that benefits a third party’s economic position may be defined as a negative cost. The sum of the private cost and the third-party cost is the social cost. The concept of social cost results from economic interdependence.
British economist Alfred Marshall (1842–1924), in his Principles of Economics, introduced the interdependence phenomenon as “external economies.” Marshall restricted himself to production. For example, external economies concern a localized industry that benefits from the neighborhood of a pool of skilled workers (Marshall  1920, pp. 266–267). The growth of an industry creates a pool of skilled workers that changes the production technology and its costs. Marshall also gave an external-diseconomies example: “English miners have opened out mines of ore which diminished the foreign demand for many of England’s products” (Marshall  1920, p. 274). English miners and mechanics have aided foreign countries to compete successfully with England’s products. For England its reduced competitiveness will be seen as negative external economies.
In 1931 economist Jacob Viner (1892–1970) launched a distinction in the term interdependence that is relevant to the concept of social cost; technological versus pecuniary external effects. A technological external effect concerns the indirect effect of an activity on consumption bundle, utility function, or production function of someone else. Marshall’s skilled-workers example regards a technological external effect. It implies that privately borne marginal costs differ from social marginal costs. Marginal cost is the extra total cost of an additional unit of production. The disparity between private and social marginal cost results in inefficiency, as the economic decision does not take into account all the relevant costs. Efficiency will be reached if marginal benefits equalize marginal costs, without ignoring the social marginal cost (both positive and negative) on others. The equality concerned is called a Pareto-efficient social-welfare situation. It is a social welfare optimum in which it is impossible to improve someone’s welfare without harming the welfare of someone else. Therefore, disparity between private and social cost offers room for Pareto-efficient changes. Social welfare may profit from changing production or consumption until private marginal costs and social marginal costs are equal to each other, without a loss for anyone. This demonstrates the relevance of the concept of social cost.
A pecuniary external effect concerns an activity of some that has a direct impact on the market prices of others. Person A’s purchase may increase Person B’s input prices. It is similar to a zero-sum game: A’s benefit is B’s loss. Marshall’s miners example is a pecuniary effect. Pecuniary external effects concern redistribution of rent, irrelevant to the concept of social cost. However, in an international context this redistribution may result nationally in welfare effects and social cost.
In the 1920s British economist Arthur C. Pigou (1877–1959) formulated a remedy to welfare inefficiencies due to inequalities between private and social marginal cost. If private marginal cost exceeds social marginal cost, there is a positive external effect. A subsidy that equalizes private and social cost enables governments to prompt social welfare. For instance, the privately borne cost of education may exceed its social cost due to the social benefits of education, i.e., negative social costs. A subsidy to the education consumer will prompt education, equalizing private to social cost, enhancing Pareto-efficiency. The subsidy will induce additional activity that promotes social good. In the reverse case, there is a negative external effect that ought to induce governments to levy a tax on the activity that causes a negative effect on society.
The Pigovian procedure is beset by a multitude of difficulties. First, the discrepancy between private and social cost depends on the scope of the external effect. Should future generations be taken into account as being part of the harmed or favored third party? Second, cost differs substantially over time. In the short run it is hard to adapt to an effect. Therefore, in the long run the cost issue of an external effect will weaken. Third, costs and benefits pertain to individuals who may value these in a subjective manner. This subjectivity blocks an objective aggregation.
Even a compensation test in which winners compensate losers is not possible without a normative element. After compensation, winners as well as losers might reverse their valuation. While applying the compensation test, a normative assumption about the distribution desired must be made. All these implementation difficulties turn the Pigovian welfare device in what, later on, economist Ronald H. Coase (b. 1910) typifies as “blackboard economics” (Coase 1988, p. 19). Pigou does not take the informational problems into account that surround his proposal. In particular, the tax-subsidy instrument becomes arduous because of diffuse external effects.
Nevertheless, the Pigovian approach is a popular line of thought in designing public policy. In particular cost-benefit analysis endeavors to cope with the measurement and aggregation problems discussed, making explicit the integral (net) sum of private and social cost. Such an analysis may, for instance, imply an appraisal of the negative social cost of safety investments in terms of the cost of a human life.
In 1960 Coase wrote The Problem of Social Cost, a paper that addressed the basic cause of the discrepancies between private and social cost. Why do markets fail to bring parties together that might be mutually profitable? For instance, Person A’s activity inflicts a harm on Person B. It is in line with the Pigovian approach to tax Person A, to prohibit A’s activity, or to make A liable for the harm inflicted on Person B. However, according to Coase, this “traditional approach has tended to obscure the nature of the choice that has to be made” (Coase 1960, p. 2).
The choice in the social-cost issue is a reciprocal choice. For example, to prohibit Person A’s activity will certainly favor Person B, but, simultaneously, it will harm A. If A’s activity brings in a benefit of $50, and if this activity harms B for $20, banning A’s activity is socially inefficient. This perspective opens new insights. Person A’s activity and Person B’s harm should be formulated in terms of property rights. Consequently, A and B will start negotiations about their conflicting rights. A market emerges, and the social-cost concept turns out to be irrelevant. A precondition is that the transaction cost is zero. This is the Coase Theorem in a nutshell.
His theorem aims to underline that in reality, transaction cost is positive. In particular, transaction cost will be substantial if great numbers of parties are involved in an external effect. These abound in modern industrialized economies (e.g., air pollution due to production and consumption). The Coasean program aims to design social arrangements that internalize social cost and minimize transaction cost. Internalized social cost will be borne by optimizing economic agents and, consequently, minimized. The Kyoto Protocol in 1997, which established CO2-emission rights among nations, is such a social arrangement. Trade on emission rights has emerged, which reduces social cost.
SEE ALSO Coase, Ronald; Coase Theorem; Cost-Benefit Analysis; Externality; Welfare Analysis; Welfare Economics
Coase, Ronald H. 1960. The Problem of Social Cost. Journal of Law and Economics 3: 1–44.
Coase, Ronald H. 1988. The Firm, the Market, and the Law. Chicago: University of Chicago Press.
Marshall, Alfred.  1920. Principles of Economics, 8th ed. London: Macmillan and Co.
Pigou, Arthur C.  1978. The Economics of Welfare, 4th ed. London: Macmillan. New York: AMS Press.
Stigler, George J., and Kenneth E. Boulding, eds. 1953. Readings in Price Theory. London: George Allen & Unwin.
Viner, J. 1931. Cost Curves and Supply Curves. Zeitschrift für Nationalökonomie. Reprinted in Readings in Price Theory. George J. Stigler and Kenneth E. Boulding, eds. 1953. London: George Allen & Unwin.
Piet de Vries