An external cost occurs when producing or consuming a good or service imposes a cost (negative effect) upon a third party.
If there are external costs in consuming a good (negative externalities), the social costs will be greater than the private cost.
The existence of external costs can lead to market failure. This is because the free market generally ignores the existence of external costs.
External marginal cost (XMC) the cost to a third party from the consumption/production of one extra unit.
Example of External Cost
Driving a car imposes a private cost on the driver (cost of petrol, tax and buying car). However, driving a car creates costs to other people in society. These can include:
Greater congestion and slower journey times for other drivers.
Cause of death for pedestrians, cyclists and other road users.
Pollution, health-related problems.
Noise pollution.
Example of Production External Cost
Producing electricity from burning coal leads to air pollution and acid rain.
Producing chemicals can cause pollution to air and water.
Diagram of external cost
This diagram shows how the existence of external costs will cause the social marginal cost to be greater than the private marginal cost. Therefore, in a free market, there will be the overconsumption of the good (Q1). Social efficiency will occur at Q2 where SMC = SMB
More examples of external cost
Playing loud music creates cost to your neighbours who are kept awake
Drinking alcohol and then driving places other road users at risk of an accident.
Smoking in an enclosed space causes passive smoking health risks to others in the room.
Building a new road causes a cost to the lost environment and increase in pollution for those living nearby.
External Benefits
An external benefit occurs when producing or consuming a good causes a benefit to a third party.
The existence of external benefits (positive externalities) means that social benefit will be greater than private benefit.
Example of external benefit
In this example, of cycling to work, there is
Private benefit
We save on a bus fare.
External benefit
Other people benefit from less traffic congestion.
Also, other people benefit from the production of less car pollution.
In this case, there is an external marginal benefit of £4 from each unit.
In this diagram, the private marginal benefit is PMB. However, consuming the good gives a benefit to other people in society. The external marginal benefit is given by the difference between private marginal benefit and social marginal benefit
In a free market, goods with external benefits can often be under-consumed because the free market ignores the external benefit to others.
Example of external benefits from consumption
Cycling to work helps to reduce the level of pollution and congestion. Therefore other road users have quicker journey times and help to reduce the level of pollution.
Reduced risk of transferring disease. If you get vaccinated, the personal benefit is your own reduction in risk of disease. However, if you are inoculated there is also an external benefit – other people in society are less likely to be infected because you are healthy.
Example of external benefits from production
Fruit tree pollination. A beekeeper produces honey, but as an external benefit, his bees help to fertilise nearby fruit trees.
Reduced global warming. A firm who produces solar panels aims to make a profit. However, increased supply of solar panels has the external benefit of reducing greenhouse gases and reducing the impact of global warming.
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