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External Costs

Definition

External costs are costs incurred by individuals or society as a result of economic activities that are not reflected in market prices. They are negative consequences that affect third parties who are not directly involved in producing or consuming goods or services.

Analogy

Imagine you live near a factory that produces loud noises and emits pollution into the air. Even though you don't work at the factory or buy its products, you still have to deal with noise pollution and poor air quality. These external costs impact your well-being without being factored into any transaction.

Related terms

Negative Externality: A negative externality occurs when an economic activity imposes external costs on third parties, leading to inefficiencies in resource allocation.

Social Optimum: The social optimum represents the ideal level of production and consumption that maximizes overall societal welfare, taking into account both private benefits and external costs.

Pigouvian Tax/Subsidy: A Pigouvian tax or subsidy is a policy tool used to internalize external costs or benefits by imposing taxes on activities with negative externalities or providing subsidies for activities with positive externalities.