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1.1.6 Externalities

Syllabus
2026
Topic
1.1.6
Level
—

Learning objectives

1.1.6a External costsDefinition of external costs.1.1.6b Examples of external costsGive and explain examples of external costs, including pollution, congestion and environmental damage.1.1.6c External benefitsDefinition of external benefits.1.1.6d Examples of external benefitsExamples of external benefits, including education, healthcare and vaccinations.1.1.6e Social cost and social benefit formulaeDefinition and formula for:• social costs = private costs + external costs• social benefits = private benefits + external benefits.

Identify costs imposed on third parties

An external cost is a negative effect of production or consumption imposed on a third party who is not directly involved in the market transaction.

The buyer and seller consider their own private costs, but an outside person or community bears an additional loss. Because this loss is not fully included in the market price, too many resources may be allocated to the harmful activity.

A producer's wage, fuel or rent payment is a private cost, not an external cost. The defining question is whether the cost falls on an uninvolved third party.

Trace pollution, congestion and damage to outside costs

Activity and effect Third party External cost
factory emissions create air pollution nearby residents poorer health, cleaning costs or reduced quality of life
extra road journeys increase congestion other road users and residents longer travel times, noise and additional pollution
production damages land, water or habitats local communities and future users lost environmental quality or productive resources

A complete example links the activity to a harmful spillover and names who bears it. Brick production, for instance, may create dust or emissions that harm nearby residents even though they did not buy or sell the bricks.

The firm's own production expense is private. Environmental damage becomes an external cost when its burden is shifted to others rather than paid by the decision-maker.

Identify benefits received by third parties

An external benefit is a positive effect of production or consumption enjoyed by a third party who is not directly involved in the market transaction.

The consumer or producer receives a private benefit, while other people gain an additional spillover benefit. Because the decision-maker does not receive all of this wider gain, the market may allocate too few resources to the beneficial activity.

The direct satisfaction received by the purchaser is a private benefit. An external benefit must accrue to someone outside the transaction.

Trace education, healthcare and vaccination spillovers

Activity Private benefit External benefit to others
education learner gains knowledge, skills and earnings potential employers and society gain a more productive, informed population
healthcare patient gains improved health reduced transmission and less pressure on families or services
vaccination vaccinated person lowers their own infection risk lower transmission protects other people, including vulnerable groups

The spillover must reach someone beyond the direct consumer. Vaccination can therefore create external benefit by reducing the chance that an infected person passes disease to others.

Government provision or payment is not what makes a benefit external. The test is whether third parties receive a positive effect.

Combine private and external effects into social totals

Social costs=private costs+external costs\mathrm{Social\ costs}=\mathrm{private\ costs}+\mathrm{external\ costs}

Social benefits=private benefits+external benefits\mathrm{Social\ benefits}=\mathrm{private\ benefits}+\mathrm{external\ benefits}

Term Whose effect is counted?
private cost or benefit buyer, seller, producer or consumer directly involved
external cost or benefit third parties outside the transaction
social total both direct and third-party effects

If production imposes 60ofprivatecostand60 of private cost and25 of pollution cost on residents, social cost is 85.Ifvaccinationgives85. If vaccination gives40 of private benefit and 30ofprotectiontoothers,socialbenefitis30 of protection to others, social benefit is70.

Add like effects: costs to costs and benefits to benefits. Do not calculate social cost using benefits or social benefit using costs.