Social cost and Benefits

Social Efficiency

A transaction is socially efficient if it accounts for all costs of production and all benefits of
consumption– that is, it factors in the social costs and social benefits.

Social Costs

Social costs are the sum of private and external costs. In markets, this can be understood as:

• Marginal private cost (MPC) is the additional private cost to the firm of producing one
more unit of a good or service. The MPC does not reflect the total economic cost of
production given that there are costs that society will have to pick up along the way.

• Marginal external cost (MEC) is the additional external cost to third-parties that result from
a firm producing one more unit of a good or service.

• Marginal social cost (MSC) is the additional cost to society as a whole when a firm
produces one more unit of a good or service. It is the sum of private and external costs of
production and can be written as: MSC=MPC+MEC.

Understanding Social Costs through Diagrams

In normal supply and demand analysis, the supply curve represents only the private costs
(Marginal Private Cost) to the producer in providing a good or service. External costs are ignored.
However, the socially efficient supply curve, or marginal social cost curve, reflects the cost to
society as a whole from production. It is made up of marginal private costs and marginal external
costs of production. This is shown in the diagram above as the MSC curve. Note that the MSC
curve is higher than the MPC curve. This is because the MSC curve is drawn to include all costs
to society from production – both private and external.

Measuring External Costs of Production

Not that from the free market output, we can estimate external costs of production. This seen as
the difference between the marginal social costs (MSC) curve and the marginal private costs
(MPC) curve – the triangular area –, measured from the free market quantity.

Social Benefit

Social benefits are the sum of private and external benefits. In markets, this can be understood as:

• Marginal private benefit (MPB) is the additional satisfaction consumers receives from
using one more unit of a good or service. This additional benefit is sometimes referred to
as marginal utility (MU), and is often measured by the price the consumer is willing to pay.
The MPB does not reflect the total gain to society from consumption as external benefits
are ignored.

• Marginal external benefit (MEB) is the additional satisfaction derived by third-parties

when a consumer uses one more unit of a good or service.

• Marginal social benefit (MSB) is the additional benefit to society as a whole when a
consumer uses one more unit of a good or service. It is the sum of private and external
benefits of consumption and can be written as: MSB=MPB+MEB.

Understanding Social Benefits through Diagrams

The demand curve represents only the private gain (Marginal Private Benefit) to the consumer
from using a good or service. External benefits generated from his consumption are ignored.
Because of this, the full benefit to society from consumption is understated.

On the other hand, the socially efficient demand curve, or marginal social benefit curve, reflects
the benefit to society as a whole from consumption. It is made up of marginal private benefits and
marginal external benefits of consumption. This is shown in the diagram above as the MSB curve.
Note that the MSB curve is higher than the MPB curve. This reflects is so because the MSB curve
is drawn to include all benefits to society from consumption – both private and external.

Measuring External Benefits of Consumption

Not that from the free market output (or the socially efficient output) we can estimate external
benefits of consumption. This seen as the difference between the marginal social benefit (MSB)
curve and the marginal private benefits (MPB) curve – the triangular area –, measured from the
free market quantity.

Social Efficiency in Markets – Combining MSC and MSB

The condition necessary for social efficiency in markets is where marginal social benefit
(MSB) = marginal social cost (MSC). At this point, society maximises social economic welfare
– social demand and supply reflect the full social costs and benefits involved, not just the private
costs and private benefits to consumers and producers.
What then is Market Failure?

When left to its own devices and totally free from any form of government intervention, the
“invisible hand” of the market mechanism works to provide an effective allocation of resources in
an economy. Demand and supply first interact to determine what goods/services are produced and
at what prices. Prices then vary with changes in the conditions of demand and supply.

When shortages exist, prices adjust upwards, encouraging producers to provide more of the good.
Conversely, surpluses are eliminated by price adjustments downwards. It is for this reason that
many believe that markets are allocatively efficient – they always “clear” in the long-run.

For many types of markets, this is true. In other circumstances, though, price adjustments fail to
provide the good at all or fail to clear excess demand or supply, giving rise to what is commonly
called market failure.

In a general way, market failure is a criticism of the market economy and all that is wrong with it.
It describes two different sets of circumstances:

 The failure of the price mechanism to achieve economic efficiency in the allocation of
society’s resources. A free market may fail to deliver either productive efficiency or
allocative efficiency, or both. Market failure typically focuses on allocative inefficiency.

 The failure of the price mechanism to serve social goals such as equity and equality.

Market failure is therefore defined as the situation where markets fail to achieve economic
efficiency (productive and allocative) and equity/equality.