Externalities, welfare loss and the socially efficient output

Overview

Private cost, external cost and relationship between private benefit, external benefit and social benefit.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define an externality.

   Model answer

   An externality is a cost or benefit falling on a third party outside the transaction. Neither the buyer nor the seller takes the effect into account.

2. 2

   Define private cost.

   Model answer

   Private cost is the cost borne by the producer or the consumer of a good. Wages, materials and the purchase price are private costs.

3. 3

   Define external cost.

   Model answer

   External cost is the cost a transaction imposes on third parties. Nobody in the market pays for it.

4. 4

   State the relationship between private cost, external cost and social cost.

   Model answer

   Social cost equals private cost plus external cost. Where external cost is zero the two measures are identical.

5. 5

   State the relationship between private benefit, external benefit and social benefit.

   Model answer

   Social benefit equals private benefit plus external benefit. External benefit is the gain enjoyed by third parties.

6. 6

   What does the marginal social cost curve show?

   Model answer

   The marginal social cost curve shows the extra cost to society of producing one more unit. The curve adds external cost to marginal private cost.

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