Concepts of externality and social cost Externality and social cost The concept of externality and social cost is dealt in welfare economics which is also called social – welfare economics.It attempts to measure welfare (social), that is, what it constitutes and how such a maximum can be attained.

Pareto optimal  The Italian economist Wilfredo Pareto stated that any change that makes at least one person better off without making anybody else worse off is an improvement in social welfare.  Conversely, a change that makes no one better off and at least one worse - off is a decrease in social welfare. This is called pareto’s optimality.

 A situation in which it is impossible to make any one better off without making some one worse-off is said to be pareto optimal or pareto efficient.  The marginal conditions for a pareto optimal or pareto efficient distribution of commodities among consumers requires that the marginal rate of substitution between two goods be the same for all the consumers.

Market Failure  Pareto’s optimality could only be achieved in a perfect market which does not exist in real world. The real markets do not achieve pareto optimality and so we say they experience market failure.  Market failure occurs when resources are misallocated or allocated inefficiently. It arises because exchange is impeded.It leads to waste or lost value.

Four important causes are identified for the market failure: i) Imperfect market structure ( monopoly, monopolistic competition, oligopoly, etc) ii) Existence of public goods iii) Presence of external costs and benefits and iv) Imperfect information

Externality  Let us a consider that a home owner keeps a beautiful garden, He incidentally and unintentionally provides pleasure to those who pass by his house.  They feel happy but do not make bay payment to the home owner. This is called beneficial externality. A factory may release its effluents into a river and pollute it.  It does not pay for cleansing the river. Such an economic production activity generates what is called detrimental externality.

 The factory does not include the cost of treating pollution it caused to the river while it prices its product, because the river belongs to the public or society.  Since a public or common property belongs to everyone in general and no one in particular, it becomes nobody’s property and polluters are free to pollute them unless there is government or social intervention.

 The cost of such detrimental externalities needs to be internalized while pricing which will be of course is passed on to the consumer. This cost is called social cost as often. It is borne by the society.  That is why governments add the condition.”Polluter pays” to such factories which means the factory should bear the social cost.

 This lack of property rights cause what is called tragedy of the commons and hence it is suggested that ownership over such public properties could be transferred to individuals or a groups of individuals otherwise called stakeholders in an appropriate and responsible way.  Externalities cause economic inefficiency in the production process which will not maximize benefits to the society.

 Hence, it is undesirable and it will not serve its own interests and that of the society in the long run.  We have open access fishery in our marine fisheries. It means any one can put a boat to catch fish in the sea, any time at his will and catch as much as he can. It is an unregulated fishing activity.

 This results in overfishing which leads to over – capitalization, enhanced cost of production, loss of non-target fish species resulting in, loss of juveniles which will affect future catches and loss of bio-diversity, labour lay- off, misallocation of resource, etc.  The government provides subsidy to the fishermen on the fuel used additionally, for new boats and nets purchased, compensation during off-season or ban period,etc which will only make fishing further unsustainable.

 The loss caused by overfishing is not included while the fish catch is priced. Government spends money to conserve marine resources and biodiversity. This is also a kind of negative externality caused by over fishing. It is also a social cost as the loss is made good by the government.  Thus, negative externalities occur due to lack of regulations and their enforcement. It could be corrected through appropriate policy interventions.