When businesses and individuals calculate the cost of producing a good or performing an activity, they often ignore costs that are not immediately apparent. For instance, a car owner considers the cost of fuel, maintenance and the value of her car, but might not consider the cost of maintaining roads or providing healthcare to individuals harmed by pollution. The cost to the car owner are referred to as private costs and indirect costs are referred to as external costs. The combination of private and external costs results in the social cost. Because there are so many variables involved when calculating the social cost of an economic activity, it can be difficult to determine.
Calculate private costs. For businesses, these are relatively simple to track. They include physical capital invested in buildings or equipment, and human capital invested in labor. For consumers, calculating private cost can be more complicated. In the example used in the introduction, the car owner may also want to include driving time or time spent washing her car as a part of her private costs.
Calculate external costs. External costs are not accounted for in a business' or individuals' private costs, but that cost something for someone. These vary and are not always obvious. A factory that contributes to the pollution of a river would create an obvious cost for the local government to clean the river and a less obvious cost for the public who would not be able to swim in the river.
Add private costs and external costs. The result is the social cost. Calculating social cost is important because it allows economists to determine whether or not certain competitive markets are operating at socially efficient output rates.
- Hemera Technologies/AbleStock.com/Getty Images