External Costs of Production (Edexcel IGCSE Economics)

Negative Externalities of Production

• Whenever the production of a good or service generates external costs, it is referred to as a negative externality of production

  • External cost = social cost - private cost

• The market is failing due to over-provision of these goods and services, as only the private costs are considered by the producers and not the external costs

  • If the external costs were considered, the quantity of goods and services provided would decrease, and the remaining units would be sold at a higher price

  • Examples of external costs include pollution, congestion and environmental damage. These all have spillover effects on third parties

Diagram: Air Pollution from Production

External costs from factory include the effects of air pollution

• External costs can be observed in the steel industry

  • Steel firms create external costs to third parties not involved in the transaction between the firm and the buyer

    • They emit greenhouse gases into the air during the production process, which contributes to climate change

    • This pollution poses health risks, particularly affecting vulnerable groups such as children and those with respiratory diseases

• As a result os these external costs, the government may need to allocate additional funds for healthcare provision to address the health issues arising from pollution-related illnesses

The Impact of External Costs & Government Intervention

• Analysing external costs and the government intervention necessary to correct them is best done by considering real world examples

• Analysis should always include the impact on stakeholders including producers, consumers, government, and relevant third parties

External Costs and Possible Government Intervention - Mining iron ore