External cost – definition

An external cost is the cost incurred by an individual, firm or community as a result of an economic transaction which they are not directly involved in. External costs, also called ‘spillovers’ and ‘third party costs’ can arise from both production and consumption.

Many, if not most transactions create external costs – examples include:

  1. Purchasing consumer goods commonly creates waste in terms of packaging, as well as other environmental costs including carbon emissions resulting from travelling to stores and outlets.
  2. Environmental costs can also arise from the production process, including direct costs from emissions and costs from transportation and distribution.
  3. Excessive fishing can deplete fish stocks and lead to unemployment in the fishing industry in the future.

Where the goods are ‘demerit goods‘, such as cigarette and alcohol consumption, governments may impose taxes to discourage consumption and reduce external costs. Information failure may result in a lack of awareness of external costs, and hence a sub-optimal level of consumption.

Diagram to show an external costs from production:

External benefits