An externality is a side effect on people outside the deal. When it is a cost, the free market makes too much of the good: market failure.
Two kinds of negative externality
Of production
A factory's smoke harms the people who live nearby.
Of consumption
Smoking harms people nearby and raises health costs for everyone.
A demerit good
Cigarettes or alcohol: consumers underestimate the harm, so they consume too much.
The points to remember
- The market stops where MPC = MPB; society wants MSC = MSB.
- With a negative externality, the market makes too much: a welfare loss.
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Start with production. The external cost is the harm to people who are not buying or selling.
Our example (made-up numbers)
| Private cost | External cost | Social cost | |
|---|---|---|---|
| Each extra tonne | MPC | + €4 | MSC = MPC + €4 |
| Market output | 40 | Optimum: 20 |
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Remember it as: The firm pays MPC; society pays MSC. The gap is the external cost.
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Consumption works the same way, with the gap on the benefit side.
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The points to remember
- A negative consumption externality: MSB below MPB.
- Market output above the social optimum: over-consumption and a welfare loss.
Paper 3 asks you to read these diagrams and calculate the welfare loss.
Three Paper 3 moves
Where is community surplus largest?
At the social optimum, where MSC = MSB: 20.
The welfare loss
½ × (40 − 20) × €4 = €40, a triangle.
Draw the missing curve
MSC parallel to MPC, above it by the external cost; label it.
How the 2 marks are given
| You write | Marks |
|---|---|
| Valid working: ½ × (Qm − Qopt) × the external cost | 1 |
| The answer with units | 1 |
| The answer only, no working | 1 |
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Quick reminder
- Axes: Costs, benefits up the side, Q along the bottom
- Production: D = MPB = MSB, S = MPC and MSC above it; MSC2 above MSC1 when the harm grows
- Consumption: D = MPB, MSB below it and S = MPC = MSC
- Marks: Qm (the market) and Qopt (the social optimum), the welfare loss between them
- Dots with dashed lines to the axes, an arrow for the shift
- No numbers, no title
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For consumption, the gap is on the benefit side: MSB lies below MPB, and the welfare loss points the other way.
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Paper 1 asked this in November 2024, as part (a) for 10 marks.
Explain why a firm ignores external costs when it plans its output.
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How the 10 marks are given
| Marks | What your answer needs |
|---|---|
| 9–10 | Theory fully explained, terms used correctly all the way through, the diagram included and fully explained |
| 7–8 | Theory explained, terms mostly right, the diagram included and explained |
| 5–6 | Theory partly explained, some terms, the diagram included |
| 1–4 | Theory only described or stated; few relevant terms |