Market Failure & Externalities

Before tackling externalities, fix three pairs of definitions.

Private cost. The cost paid by the producer or consumer in the transaction itself. Example: a factory's wage bill and electricity bill; a smoker's £12 packet of cigarettes.

External cost. The cost imposed on third parties outside the transaction. Example: smoke pollution affecting neighbours; passive-smoking harm to bystanders.

Social cost. The total cost to society. Social cost = private cost + external cost.

The same three definitions exist on the benefit side.

Private benefit. The benefit gained by the producer or consumer of the good.

External benefit. The benefit enjoyed by third parties outside the transaction.

Social benefit. Social benefit = private benefit + external benefit.

Two patterns that examiners test repeatedly:

• When social cost > private cost, the gap is an external cost (negative externality). The market over-produces.
• When social benefit > private benefit, the gap is an external benefit (positive externality). The market under-produces.