ANNEX
Definition of externalities
The term "externalities" usually refers to the phenomenon whereby an individual’s well-being, or
the conditions of production of a firm, are affected by the action of an economic agent who does not bear the
consequences of that action; more importantly, the action does not give rise to a monetary transfer. Transport
noise, for instance, may disturb local residents and reduce productivity. Consequently, the cost of transport
to the community as a whole, or "social cost", covers not only the private cost borne by the operator but also
external costs, the sum of which can be written as follows:
Social costs = Private costs + External costs.
However, this does not tell us much about the type of costs involved. Private costs can be divided
into average cost, marginal cost, and incremental cost. For the purposes of pricing, other methods of
calculating costs, such as the Shapley value, can be used. Costs can be calculated using a cost function which
relates overall expenditure to the volume of each class of traffic. But it is also necessary to determine whether
expenditure is adequate to cover costs; when it is not (usually because of market failure) shadow prices may
have to be set for some goods. This can arise in particular with capital costs.
The same complications arise when measuring externalities, since external costs can be defined
precisely only with reference to a specific problem (the internalisation of costs through taxes, for instance; it
can also be useful to measure external effects prior to making an investment or to taking action in many other
areas). It is also important to specify the model that is being used (in the case of internalisation, prices can be
calculated using a Ramsey-Boiteux budget equilibrium constraint model, or the Shapley value). Every
problem and every policy response will place a different value on social cost.
Thus, external costs are not absolute values, but will vary according to the purpose of the
calculations. This report defines social costs for the purposes of macroeconomic comparison, but they would
have to be defined differently, and the figures would not be the same, if the aim were to calculate optimal
taxes.
Lastly, externalities need to be distinguished from rent. Rent is the profit that the owner of an asset
that is in fixed supply derives from a rise in its price. A property owner, for instance, makes a capital gain on
a piece of land when its market value rises as a result of the construction of new infrastructure in the vicinity.
Similarly, a hairdresser’s income can rise not because his productivity has risen but because that of other
workers has increased, thereby pushing up average wages. These examples are (sometimes wrongly) called
pecuniary externalities.
It is also somewhat inaccurate to speak of externalities in respect of a good that can be purchased at
a price that is not the "normal" price (i.e. the price that would be charged if the market was clearing
normally). This is usually the case for goods whose prices are controlled to some degree (e.g. goods
supplied by a subsidised government monopoly). Before concluding that the difference between the actual
and the "normal" price should be corrected, the reasons for the difference should first be ascertained.