Understanding Externalities (Edexcel IGCSE Economics)

Externalities: Costs & Benefits

• Externalities occur when there is an external impact on a third party not involved in the economic transaction

  • These impacts can be positive or negative and are often referred to as spillover effects

  • These impacts can be on the production side of the market (producer supply) or on the consumption side of the market (consumer demand)
    

• External costs occur when the social costs of an economic transaction are greater than the private costs

  • A private cost for the producer is what they actually pay to produce a good/service

  • An external cost (negative externality) is the damage not factored in to the economic activity (for example, generating air pollution when producing electricity)

  • Private cost + external cost = social costs

• External benefits occur when the social benefits of an economic transaction are greater than the private benefits

  • A private benefit for the consumer is what they personally gain from consuming a good/service

  • An external benefit (positive externality) is the benefit not factored in to the economic activity (for example, someone who studies law enjoys private benefits but society benefits from having strong legal institutions)

  • Private benefit + external benefit = social benefits