4.3.2 Externalities

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    Private costs

    • Producers are concerned with private costs of production. For example, the rent, the

    cost of machinery and labour, insurance, transport and paying for raw materials are

    private costs.

    • This determines how much the producer will supply.
    • It could refer to the market price which the consumer pays for the good.
    • Marginal private cost is the cost to a firm of producing one extra unit.

    Social costs

    • This is calculated by private costs plus external costs
    • External costs are the difference between private costs and social costs and are not reflected in the price paid for the product.
    • External costs increase disproportionately with increased output.
    • Marginal social cost is the extra cost on society derived per extra unit consumed.
    • Marginal social cost = marginal external cost + marginal private cost

    Private benefit

    • Consumers are concerned with the private benefit derived from the consumption of

    a good. The price the consumer is prepared to pay determines this.

    • Private benefits could also be a firm’s revenue from selling a good.

    Social benefit

    • Social benefits are private benefits plus external benefits.
    • External benefits are the difference between private and social benefits.
    • Similarly to external costs, external benefits increase disproportionately as output

    increases.

    • Marginal social benefit is the extra benefit on society derived per extra unit

    consumed.

    • Marginal social benefit = marginal external benefit + marginal private benefit

    Negative externalities are caused by demerit goods, whilst merit goods cause positive externalities. It is difficult to judge the monetary value of an externality as it affects different people in different ways, which also makes choosing different government policies difficult.

    The impact on society of charging prices that do not reflect total internal and external costs

    The price paid only reflects the producer’s costs (and their profit margin). This means that there is no compensation paid to those that suffer from the negative externalities., such as pollution. As the price for such a good is too low, it will cause overconsumption, meaning more profit is made by the producer. Due to the external cost, many people will suffer and in the case of pollution money is spent by others to reduce it adding a monetary cost.

    Environmental externalities

    The consumption of energy, sourced from resources such as coal and natural gas, results in negative externalities. These are visible in the form of pollution. There could be excess air pollution, scarring of the landscape and noise. However, the price of energy does not reflect the negative externalities and social costs which result from energy use.

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