External costs vs internal costs

External costs vs
internal costs

Internal costs are easy to see and explain. They are costs that a business bases its price on. They include costs like materials, energy, labour, plant and equipment and overheads.

External costs are costs that are NOT included in what the business bases its price on. These include:

the cost of disposing of the product at the end of its useful life
the environmental degradation caused by the emissions, pollutants and wastes that production creates
the cost of health problems caused by toxic ingredients

Even though external costs are not included in the price of the product they must still be paid. They end up being paid by society through taxes, accident compensation, medical and insurance payments and also by future generations through losses in environmental quality and natural capital.

The sorts of products and services that include external costs (e.g. organic produce, clean technology, natural products) are usually more expensive than those that don't. Consumers will tend to buy the cheapest goods so clean products are at a disadvantage.

One way to include external costs in prices is for governments to tax those products or activities that have them. The restructuring of taxes, which is often called 'tax shifting', would mean that good things (like incomes) are not taxed whilst bad things (like pollution) are. In a column in Fortune Magazine, Harvard economics professor N. Gregory Mankiw succinctly sums up the idea of tax shifting: "Cutting income taxes while increasing gasoline taxes would lead to more rapid economic growth, less traffic congestion, safer roads, and reduced risk of global warming--all without jeopardizing long-term fiscal solvency. This may be the closest thing to a free lunch that economics has to offer."

In fact, taxing external costs to society is not new. Cigarettes and alcohol are taxed to cover their external health and social costs. Smokers and cigarette companies may rail against these taxes but most people will realise it isn't fair that society as a whole should pay these external costs. The other key benefit of adding a tax is a financial disincentive to the practice of smoking.

Ideas like carbon taxes, levies on petrol and vehicle use, and other environmental taxes are similar to cigarette and alcohol taxes. By internalising external costs the product or service can factor it's true cost.

See also True Cost