External Costs and Benefits

An external cost is an uncompensated cost that an individual or firm imposes on others.

The environmental costs of pollution are the best known and most important example of an external cost—an uncompensated cost that an individual or firm imposes on others. In a modern economy there are many examples of an external cost that an individual or firm imposes on others. A very familiar one is the external cost of traffic congestion: an individual who chooses to drive during rush hour increases congestion and has no incentive to take into account the inconvenience inflicted on other drivers. Another familiar example is the cost created by people who text while driving, increasing the risk of accidents that will harm others as well as themselves (see the upcoming For Inquiring Minds).

Pollution leads to an external cost because in the absence of government intervention those who decide how much pollution to create have no incentive to take into account the costs of pollution that they impose on others. In the case of air pollution from a coal-fired power plant, the power company has no incentive to take into account the health costs imposed upon people who breathe dirty air. Instead, the company’s incentives are determined by the private monetary costs and benefits of generating power, such as the price of coal, the price earned for a kilowatt of energy, and so on.

An external benefit is a benefit that an individual or firm confers on others without receiving compensation.

External costs and benefits are known as externalities. External costs are negative externalities, and external benefits are positive externalities.

We’ll see later in this chapter that there are also important examples of external benefits, benefits that individuals or firms confer on others without receiving compensation. For example, when you get a flu shot, you are less likely to pass on the flu virus to your roommates. Yet you alone incur the monetary cost of the vaccination and the painful jab. Businesses that develop new technologies also generate external benefits, because their ideas often contribute to innovation by other firms.

External costs and benefits are jointly known as externalities, with external costs called negative externalities and external benefits called positive externalities. Externalities can lead to private decisions—that is, decisions by individuals or firms—that are not optimal for society as a whole. Let’s take a closer look at why.

!worldview! FOR INQUIRING MINDS: Talking, Texting, and Driving

Why is that person in the car in front of us driving so erratically? Is the driver drunk? No, the driver is talking on the phone or texting.

Traffic safety experts take the risks posed by driving while using a cell phone very seriously: A recent study found a six-fold increase in accidents caused by this type of driving while distracted. And in 2012, the National Safety Council estimated that nearly 250,000, or one in four traffic accidents, was attributed to the use of cell phones while driving.

One estimate suggests that talking while driving may be responsible for 3,000 or more traffic deaths each year. And using hands-free, voice-activated devices to make a call doesn’t seem to help much because the main danger is distraction. As one traffic consultant put it, “It’s not where your eyes are; it’s where your head is.”

Using a cell phone while driving makes you a danger to others as well as yourself.
Steve Debenport/Getty Images

The National Safety Council urges people not to use cell-phones while driving. Most states have some restrictions on cell-phone use while driving. But in response to a growing number of accidents, several states have banned cell-phone use behind the wheel altogether. In 43 states and the District of Columbia, it is illegal to text and drive. Cell-phone use while driving is illegal in many other countries as well, including Japan and Israel.

Why not leave the decision up to the driver? Because the risk posed by driving while using a cell phone isn’t just a risk to the driver; it’s also a safety risk to others—to a driver’s passengers, pedestrians, and people in other cars. Even if you decide that the benefit to you of using your cell phone while driving is worth the cost, you aren’t taking into account the cost to other people. Driving while using a cell phone, in other words, generates a serious—and sometimes fatal—negative externality.