🏭 Pollution
A factory pumps smoke into the air. Nearby families breathe it in and may become ill. The factory does not pay for their treatment.
Externalities » Externalities: Social Costs and Benefits
What you'll learn this session
Study time: 30 minutes
Edexcel spec: 1.1.6 (a)-(e)
- What external costs of production are, with examples
- What external benefits of consumption are, with examples
- How to work out social costs and social benefits
- How to answer a calculation question on externalities
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Unlock This CourseCosts and benefits that land on other people
When you buy a cup of tea, you pay for it and you enjoy it. The café sells it and makes a profit. Everyone involved in the deal gets something or pays something. But some deals also affect other people who were not part of the deal at all. This lesson is about those side effects. It is examined on Paper 1 (Microeconomics and Business Economics).
In an earlier lesson you saw that market failure happens when resources are not allocated well. Externalities are one important reason for it.
Key terms:
- Private costs: the costs paid by the individual or firm that makes or buys something.
- Private benefits: the benefits gained by the individual or firm that makes or buys something.
- External costs: costs that fall on people other than the producer or consumer, who are not paid for them.
- External benefits: benefits that go to people other than the producer or consumer, who do not pay for them.
- Social costs: the total cost to society: private costs plus external costs.
- Social benefits: the total benefit to society: private benefits plus external benefits.
External costs of production
Smoke from a factory harms people nearby who never agreed to pay that cost: an external cost of production
Producers pay for things like wages, materials and electricity. These are private costs. But production can also harm other people, and the producer does not pay for that harm. These are external costs of production.
🚗 Congestion
A new warehouse sends hundreds of lorries along a town's roads each day. Other drivers sit in traffic, lose time and use more fuel.
🌳 Environmental damage
A mining company clears a forest and leaves waste in a river. Wildlife is lost and local people cannot use the river.
In each case the people who suffer did not choose the activity and were not paid for putting up with it. That is why the cost is called external.
External benefits of consumption
A vaccination protects other people too, not just the patient: an external benefit of consumption
Externalities can be good too. Sometimes when people consume a good or service, other people gain as well, and they do not pay for it. These are external benefits of consumption.
🎓 Education
An educated person earns more, which helps them. But employers get skilled workers and the country gets a more productive workforce.
🏥 Healthcare
A person who is treated gets better. Their family does not have to care for them, and they can return to work and help their employer.
💉 Vaccinations
A vaccinated person is protected. They are also less likely to pass the disease on, so people around them are safer too.
Private versus social: the formulas
Economists add up the whole picture. The cost to society is the cost to the producer plus the cost to everyone else. The benefit to society is the benefit to the buyer plus the benefit to everyone else.
Learn these two formulas
Social costs = private costs + external costs
Social benefits = private benefits + external benefits
You can rearrange them. External costs = social costs - private costs. External benefits = social benefits - private benefits.
Worked example 1: social costs
A chemical firm spends 50 million Zed a year on wages, materials and energy. Its factory pollutes a river. Cleaning the river would cost 12 million Zed a year.
Private costs = 50 million Zed. External costs = 12 million Zed.
Social costs = 50 + 12 = 62 million Zed.
Worked example 2: social benefits
A free flu vaccination programme gives 8 million Zed of benefit to the people who are vaccinated. It also saves 5 million Zed for others, because fewer people catch the illness and miss work.
Private benefits = 8 million Zed. External benefits = 5 million Zed.
Social benefits = 8 + 5 = 13 million Zed.
Worked example 3: finding the missing figure
A bus company's private costs are 400,000 Zed a year. The social costs of its service are 460,000 Zed a year.
External costs = social costs - private costs = 460,000 - 400,000 = 60,000 Zed.
Why this matters
A firm looks at its own private costs and a buyer looks at their own private benefits. They usually ignore the external part. So the market may make too much of a good that causes external costs, such as a polluting product. It may make too little of a good that creates external benefits, such as vaccinations. This is a failure of the market to use resources well. How governments respond is covered later, in the lesson Government Policies for Externalities.
Common mistakes
- Saying an external cost is any cost to the firm. It is not. A firm's wage bill is a private cost. An external cost falls on other people.
- Only writing "pollution is bad". Say who suffers and why they are not paid for it.
- Mixing up the two types: in this spec, external costs are linked to production and external benefits to consumption.
- Forgetting to add. Social costs are bigger than private costs when there is an external cost. Only subtract if the question asks you to find the external cost.
Exam-style question
Read the context, then answer the questions. This is a Paper 1 style question.
A cement works in Country M has private costs of 90 million Zed a year. The dust from its chimneys makes people in nearby villages ill. The cost of this illness to the villagers and the local health service is 15 million Zed a year.
(a) Define external costs. [2 marks]
(b) Calculate the social costs of the cement works. [2 marks]
(c) Explain one external benefit of consumption, other than education. [3 marks]
Model answer
(a) External costs are costs that fall on people other than the producer or consumer (1), who are not paid for them (1).
(b) Social costs = private costs + external costs (1) = 90 + 15 = 105 million Zed (1).
(c) Vaccination is an example. The person who is vaccinated gains protection (1). They are also less likely to pass on the disease, so other people are less likely to catch it (1). These people gain without paying, so this is an external benefit (1).
Exam tip
In a calculation, write the formula first, then your numbers, then the answer with its units. Here that means "105 million Zed", not just "105".