Social costs – or externalities, in the language of standard economics – are harmful effects that are not internalized in the production costs of enterprises. Therefore, market prices do not include externalities. The first analyses of externalities were made by the Cambridge economist, Arthur C. Pigou, in the 1920s. In order to be recognized as social costs, externalities must have two characteristics: (1) it must be possible to avoid them; and (2) they must be part of the course of productive activities and be shifted to third persons or the community at large (Kapp, 1963). Pollution, for instance, can be traced to productive activities and can be shown to be human-made and avoidable. As the great ecological and institutional economist K.W. Kapp (1969) argued, ‘the basic causes of social costs are to be found in the fact that the pursuit of private gain places a premium on the minimisation of the private costs of current production. Therefore … the more reliance an economic system places on private incentives and the pursuit of private gain, the greater the danger that it will give rise to external “unpaid” social costs unless appropriate measures are taken to avoid or at least minimize these costs’. State regulation would be required to avoid the externalities.
By shifting part of the costs of production to third persons or to the community at large, producers are able to save costs or to appropriate a larger share of natural resources than they would otherwise be able to do. Alternatively, it may be claimed that consumers who purchase the products will get them at lower prices than they would have been able to do had producers been forced to pay the total costs of production. Similarly, the cost of waste disposal is cheaper when the service is done in such a way that harmful effects are not avoided. The fact that social costs raise issues of income redistribution makes them matters of political controversy and power relations.
Environmental problems associated with trade of natural resources include ecosystem destruction, biodiversity loss, and land, water and air pollution. Worsening terms of trade prevent internalisation of these social and environmental externalities. In this sense, countries or regions specialized in extraction activities where commodity prices tend to fall over time will have fewer opportunities to internalize environmental costs into prices. Moreover, private sector practices, such as transfer pricing, can make the situation even worse. If international conditions determining prices make the South less able to internalize externalities, then there is a transfer of wealth from poor countries to rich countries, or, in other words, the North is transferring environmental costs to poor countries. This mechanism is referred to as ‘ecologically unequal exchange’. This is similar to sending waste generated in rich countries to poor countries.
Kapp, K.W. (1963) Social costs of business enterprise. Second enlarged edition. Bombay/London: Asia Publishing House.
Kapp, K.W. (1969) On the nature and significance of social costs. Kyklos, XXII (2) 334-347.
For further reading:
Martinez-Alier, J. (2001) Mining conflicts, environmental justice, and valuation. Journal of Hazardous Materials 86 153-170.
Martinez-Alier, J. and O‘Connor M. (1999) Distributional issues: an overview. In: J. Van den Bergh (ed.) Handbook of environmental and resource economics. Cheltenham, Edward Elgar.
This glossary entry is based on a contribution by Julien Francois Gerber
EJOLT glossary editors: Hali Healy, Sylvia Lorek and Beatriz Rodríguez-Labajos