External costs are related to the principles of welfare economic, and refer to the idea that activities developed by a certain party can adversely affect the well-being of a third party, e.g. the next door neighbors of a nuclear power plant.
By definition, private markets do not include external effects or their costs in their investment projects. It is therefore important to identify the external effects and then to monetise the related external costs, for example, with the help of a Social cost-benefit analysis. This so-called "internalisation" of external effects has to be achieved by adequate policy measures, such as taxes.
Types of external effects
Externalities can be classified in two main categories:
- Environmental and human health externalities: "These can additionally be classified as local, regional or global, referring to climate change caused by emissions of CO2 or destruction of the ozone layer by emissions of CFCs or SF6" .
- Non-environmental externalities: "Hidden costs, such as those borne by tax-payers in the form of subsidies, research and development costs, or benefits like employment opportunities, although for the latter it is debatable whether it constitutes an external benefit in the welfare economics sense".
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Footnotes and references
- European Commission (1994): Common Market Expert Group, The Economic Cost of Traffic Accidents.COST 313.
- The European Wind Energy Association (EWEA). Wind Energy; The Facts. Online: http://www.ewea.org/eu-funded-projects/completed-projects/wind-energy-the-facts-ii/