Science Fair Project Encyclopedia
In economics external cost refers to a negative side-effect of an economic transaction, an act of exchange, consumption, or production. It is the opposite of an external benefit and is often called a "negative externality." In a voluntary economic transaction between person X and Y, an external cost may be imposed involuntarily on individual Z, violating their freedom of choice.
The full cost of an activity is often called the social cost and includes the cost to the indididual cost plus the external or spill-over cost. For example, if I buy paper, the full cost includes not only the price I pay for it (individual cost), but also the pollution produced by the paper-mill (the external cost).
Not only does producing something sometimes involve an external cost, but consumption can also have this kind of cost: consider the cost to you if your neighbor plays his or her music too loud at 2 a.m.
If the production of an item involves an external cost, even a totally competitive market suffers from allocative inefficiency.
Technical external costs (such as pollution) directly affect the lives of others, while pecuniary external costs work through markets. As an example of the latter, if a major employer in a town goes bankrupt, it imposes unemployment, decreased income, and the like on some or many people in the town.
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