External costs are costs imposed upon a third party when goods and services are produced and consumed. Goods and services with external costs are effectively being subsidised by society-at-large which ends up paying them.

External costs vs
Internal costs

External 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, 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 from production
  • the cost of health problems caused by harmful materials and ingredients
  • social costs associated with increasing unemployment due to increasing automation

Even though external costs are not included in the price of the product they still have to be paid. Society ends up paying them through taxes, accident compensation, medical payments, insurance payments and also through losses in environmental quality and natural capital.

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

One way to include external costs is for governments to add a tax directly to those products or activities that have them. The restructuring of taxes, which is often called ‘tax shifting’, would mean that good things 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 jeopardising long-term fiscal solvency. This may be the closest thing to a free lunch that economics has to offer.”

Taxing external costs to society is not new. Cigarettes for example are taxed to cover their external health and social costs. Smokers and cigarette companies rail against these taxes but most people agree that it isn’t fair for society to pay these external costs. External costs should be directed at the users.

As well as paying the external cost the other important benefit of adding a tax to harmful and destructive practices (including cigarettes, alcohol, pollution and greenhouse gases) is that it is a financial disincentive. In theory the harmless, non-destructive option will become the same price or cheaper.

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