Social cost is higher than economic cost because

Correct — C, (c) cost borne by bystanders is positive. A bystander is somebody who is neither the buyer nor the seller in a transaction but who bears part of its consequences, and the whole of this question turns on that one word.

The cost a producer counts is the cost it actually bears: wages, materials, power, rent, interest, and the implicit opportunity cost of the resources its owners have tied up. That is the economic cost of the activity — the figure that enters the firm's own calculation and the market price. Social cost is the same activity valued from society's side of the ledger, and it is the sum of two things: the cost borne by the parties to the transaction, plus the cost imposed on everyone else. In the standard notation, marginal social cost equals marginal private cost plus marginal external cost.

So the two figures diverge only when that second term is not zero, and social cost exceeds economic cost precisely when the external term is positive — when the bystanders are bearing a real cost. A coal-fired plant sells power at a price that covers coal, labour and capital; the villages downwind bear the respiratory illness, the crop damage and the soot, and nobody bills the plant for it. Add the bystanders' burden to the plant's own and the social cost of the electricity is higher than its economic cost. That is a negative externality, and the gap between the two curves is the measure of it.

Notice that the option is stated as a condition rather than as a description, and that is what makes it right. If the bystanders' cost were zero the two figures would coincide; if it were negative — that is, if bystanders gained, as neighbours do from a vaccinated household or a well-kept garden — social cost would be lower than economic cost, and the market would be producing too little rather than too much. Only when the third-party cost is positive does the inequality in the stem hold, so (c) states the exact condition the stem asserts.

The practical consequence follows immediately. Where marginal social cost exceeds marginal private cost, the market equilibrium output is larger than the socially optimal output, because the producer is deciding on a cost figure that leaves part of the damage out. The classical remedy is to make the producer face the missing cost — the Pigouvian tax — which is exactly what the next question in this paper asks about.

Why the others are wrong

• (a)society is bigger than economy — This substitutes a statement about the relative size of two entities for a statement about who bears a cost, and the two have nothing to do with each other. Costs are not compared by counting how many people or institutions fall inside a boundary; they are compared by adding up the burdens actually imposed. Social cost would exceed economic cost even in a society of two people, provided one of them bore part of the cost of the other's activity, and it would equal economic cost in a society of a billion if no activity ever spilled over. The size of society is not the variable that drives the divergence.
• (b)society includes polity, while economy does not include it — Whether the polity falls inside the definition of society is irrelevant to the arithmetic. The divergence between social and economic cost arises from a spillover onto third parties, and that spillover happens whether or not political institutions are counted in. This option is also the sort of distractor that tempts a candidate who is reading the words 'social' and 'economic' as labels for two academic disciplines rather than as two cost concepts. Read them as cost concepts and the option says nothing about cost at all.
• (d)society includes both consumers and producers — The statement is true of society but it cannot produce the inequality. Both parties to a transaction — the producer and the consumer — already have their costs counted in the private, or economic, cost figure; that is what makes it the cost of the transaction. Adding them together a second time under the name 'society' changes nothing. For social cost to exceed economic cost, the extra burden must fall on somebody who is neither the producer nor the consumer, which is precisely the bystander of option (c). This distractor is the closest of the three, because it correctly identifies that social cost is a wider concept, and then names the wrong people as the source of the extra.

An externality is a cost or a benefit that a transaction imposes on a party outside it, and that the price of the transaction therefore does not reflect. Where the spillover is a cost — factory smoke, effluent in a river, traffic congestion, second-hand smoke — the externality is negative, marginal social cost lies above marginal private cost, and the free market overproduces relative to the socially optimal level. Where the spillover is a benefit — vaccination, education, research whose results others can use, a restored heritage building — the externality is positive, marginal social benefit lies above marginal private benefit, and the market underproduces. A. C. Pigou set out the analysis in The Economics of Welfare (1920) as a divergence between marginal private and marginal social net product, and proposed the corrective tax that now bears his name: a levy equal to the marginal external damage at the optimal output, which internalises the externality by making the producer's own cost curve coincide with society's. Ronald Coase, in The Problem of Social Cost (1960), argued from the other side — that where property rights are clearly assigned and bargaining costs are low, the parties can negotiate to the efficient outcome without a tax at all. Alongside the tax and the bargain sit the other standard instruments: tradable emission permits, regulation of quantity or technology, and liability rules.

Key facts

• Marginal social cost equals marginal private cost plus marginal external cost.
• A bystander is a third party who is neither buyer nor seller but bears part of the consequences of the transaction.
• Social cost exceeds private cost when the external cost is positive — a negative externality.
• Social cost falls short of private cost when the spillover is a benefit — a positive externality.
• Under a negative externality the market equilibrium output exceeds the socially optimal output.
• Economic cost, as distinct from accounting cost, includes both explicit money outlays and the implicit opportunity cost of owner-supplied resources.
• A. C. Pigou set out the private-social divergence in The Economics of Welfare (1920) and proposed the corrective tax named after him.
• Ronald Coase, in The Problem of Social Cost (1960), showed that clear property rights and low bargaining costs can deliver the efficient outcome without a tax.
• Other instruments for internalising an externality: tradable emission permits, quantity or technology regulation, and liability rules.

Common traps

• Reading 'social' and 'economic' as the names of two disciplines rather than as two ways of measuring the same cost.
• Forgetting that the inequality reverses under a positive externality, so the sign of the external term is the whole answer.
• Confusing a negative externality with a loss to the producer; the defining feature is that the cost falls on somebody outside the transaction.
• Assuming a negative externality means the market produces too little — it produces too much, because part of the cost is invisible to the producer.
• Confusing economic cost with accounting cost; economic cost adds the implicit opportunity cost of the owners' own resources.

• practice — not a real PYQ

  In the presence of a negative externality in production, which one of the following is correct?

  • (a)Marginal social cost lies below marginal private cost and the market underproduces
  • (b)Marginal social cost lies above marginal private cost and the market overproduces
  • (c)Marginal social cost equals marginal private cost and the market outcome is efficient
  • (d)The good becomes non-rival and non-excludable

  Answer(b) Marginal social cost lies above marginal private cost and the market overproduces

• practice — not a real PYQ

  The divergence between marginal private net product and marginal social net product, and a corrective tax to remove it, were set out by

  • (a)Ronald Coase
  • (b)A. C. Pigou
  • (c)Vilfredo Pareto
  • (d)Alfred Marshall

  Answer(b) A. C. Pigou