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In economics external cost refers to a negative side-effect of an economic transaction, an act of exchange, consumption, or production. It is the opposite of an external benefit and is often called a "negative externality." In a voluntary economic transaction between person X and Y, an external cost may be imposed involuntarily on individual Z, violating their freedom of choice.
The full cost of an activity is often called the social cost and includes the cost to the individual cost plus the external or spill-over cost. For example, if I buy paper, the full cost includes not only the price I pay for it (individual cost), but also the pollution produced by the paper-mill (the external cost).
Not only does producing something sometimes involve an external cost, but consumption can also have this kind of cost: consider the cost to you if your neighbor plays his or her music too loud at 2 a.m.
If the production of an item involves an external cost, even a totally competitive market suffers from allocative inefficiency.
Technical external costs (such as pollution) directly affect the lives of others, while pecuniary external costs work through markets. As an example of the latter, if a major employer in a town goes bankrupt, it imposes unemployment, decreased income, and the like on some or many people in the town.
External costs can become internal costs. For example, residents of a community may bear the cost of air pollution from a company through poor health. This is an external cost. However, new legislation may make it illegal for a company to produce air pollution. At that time the external cost becomes an internal cost for the company as they bear the cost of finding ways not to produce the air pollution. Factors that can lead to external costs becoming internal costs include community, economic and market-based pressures.
External costs categories
There are different categories of external costs. Environmental external costs refer to a cost or sacrifice paid or borne by someone else other then the entity causing the environmental impact. For example, a company producing hazardous chemicals that are killing fish are causing a cost for people who rely on the fish as a food or income source. Other categories of external costs address the impact of a company's activities or products on people, communities and society as a whole. Many of these external costs are not identified, measured or reported under conventional accounting systems.
See also
"External cost"