A) Distinction between private costs, external costs and social costs

Private costs – The cost borne by either the producer or consumer directly involved in the economics transaction. For example, the cost to the producer of building an airport would include things such as the land, labour and capital required to make it.

External costs – The cost borne by those that have no direct involvement in the economic transaction (third parties). For example, the construction of an airport may result in noise pollution, which is a negative impact on those who live nearby.  

Social costs – The cost to society as a result of the economic transaction made. This will take into account the private costs to the consumer or producer as well as the external costs to those not involved in the initial transaction. Social costs = private costs + external costs.


B) Distinction between private benefits, external benefits and social benefits

Private benefits – The benefit received from those involved directly in the economic transaction such as, the revenue gained by the producer once the airport opens. On the consumer level it may be the decision to exercise. The benefit for that individual would be a decreased risk of heart disease.

External benefits – The benefit received from those who are not directly involved in the economic transaction. For example, the opening of an airport gives lots of job opportunities for those unemployed in the local area, giving them a stable income source. This will then result in an increase in the local standard of living.

Social benefits – The benefit to society as a result of the economic transaction made. Social benefits = private benefits + external benefits.


C) Use of a diagram to illustrate:

  • The external costs of production using marginal analysis
  • The distinction between market equilibrium and social optimum position
  • Identification of welfare loss area


Negative externalities

These are costs to third party agents that aren’t involved in the initial economic transaction meaning the free market does not take these costs into account. This leads to an overproduction and overconsumption of certain goods/services caused by consumer and firms acting in their own self-interest rather than the interests of society as a whole.



Negative externalities over production

The main example of a negative externality caused by the over production of a good/service is pollution. This often harms third parties who are not stakeholders of the firm. This includes people suffering from asthma who can suffer serious health issues as a result of the inhalation of excessive amounts of pollution. Furthermore, excessive pollution also damages the environment which adds to the effect of climate change thus having a big impact on society in the future. Firms may also dump waste in rivers causing harm to wildlife. Another example of an external cost is noise pollution caused by aeroplanes which has a negative effect on those living in the local area. The supply curve on the negative externality diagram represents the cost to society and private firms, whereas the demand curve represents the benefits to society and to private firms. Another difference that the externality diagram has to an ordinary supply and demand diagram is the vertical axis which is labelled costs/benefits rather than price. Whenever drawing an externality diagram, it is always the social curve that is moved, whether that is marginal social cost or marginal social benefit. First of all, label the curve that is not being moved. In this case it is the demand curve which is labelled as MSB/MPB (marginal social benefit/marginal private benefit). The demand curve is linked to consumption which consumers gain benefit from.  As overproduction is a supply side issue, the supply curve represents the costs to private firms and society. The marginal private cost stays the same; whereas the marginal social cost moves left as it is a negative externality. This is because the negative externality is caused by the marginal social cost being higher than the marginal private cost. As private firms act in their own self-interest, they will produce at the private optimum level (b), resulting in price P1 and quantity Q1. On the other hand the socially optimum level is at point c. This means that from quantity Q1 to Qsop, the marginal social cost of producing each extra unit is higher than the marginal social benefit. As a result, a welfare loss to society of c-a-b takes place. A good way of remembering how to draw welfare loss (a-b-c) is that it always points towards the socially optimum point (c). As the private costs are lower than the social costs it means that firms produce up to the quantity Q1 rather than Qsop. This is a rational thing for private firms to do as they have no reason to stop producing their goods/services until their private marginal benefit is equal to their private marginal costs.



Negative externalities over consumption

One of the main examples of overconsumption is of cigarettes. The over consumption of cigarettes by consumers can result in third parties breathing in smoke, despite themselves not smoking. Breathing in too much of this third person smoke can result in health implications such as lung cancer. However, as consumers act in the own self-interest they do not take this into account and therefore consume cigarettes at the point where their private benefit is equal to their private cost (private social optimum point). Therefore consumption will continue from Qsop to Q1 despite the social costs being greater than the social benefits. This causes cigarettes to be bought at the price P1 rather than Psop and consumed at the point Q1 rather than Qsop. Overall, this leads to a welfare loss to society of a-b-c. 


D) Use of a diagram to illustrate:

  • The external benefits of consumption using marginal analysis
  • The distinction between market equilibrium and social optimum position
  • Identification of welfare gain area


Positive externalities

These are third party benefits that occur as a result of the actions of a separate agent. However, due to the under consumption or underproduction of these goods/service, society misses out on some of these benefits. This causes a welfare loss to society.


Under consumption

Positive externality under consumption

An example of a good/service that is unconsumed is vaccinations. The consumption of vaccinations helps to protect the consumer from certain diseases such as the flu. As a result of this, the consumer is then less likely to catch the flu and therefore less likely to pass it onto a third party. Therefore as well as the consumer benefiting from the protection of flu, so are third party agents. However, many people don’t have vaccinations that they are eligible for causing them to be under consumed. This is because although they know the benefits and costs of taking the vaccination themselves, they don’t take into account the third party benefits and to a society as a whole. As a result of this, consumers only consume up to the private optimum level (c) rather than the socially optimum level (b). This causes vaccinations to be under consumed. Instead of the quantity consumed being at Qsop it is at Q1. This means that the quantity Q1 to Qsop is not being consumed causing society to miss out on the benefit gained from the consumption of quantity Q1 to Qsop. This is because from Q1 to Qsop the marginal social benefit is higher than the marginal social cost. This leads to the welfare loss of area a-b-c. Another good example of under consumption is of education. Students sometimes drop out of school at some point before higher education. This means that they are missing out on the potential of expanding their knowledge and having a higher earning potential. A higher earning potential would mean that the consumer would pay increased taxes in the future. This will then go to the government to spend on areas such as the NHS which benefits third parties. If the consumer was not to partake in higher education, their earning potential is likely to be less meaning that in the future they will pay less into the progressive tax system. This means that the government will not receive as much tax from that consumer compared to if they continued into higher education. Therefore the extra tax that the consumer may have payed will no longer go to areas such as the NHS causing the potential benefits to the third party to be lost. In addition to this, with higher education comes increased knowledge. For example, someone studying medicine may become a doctor.

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