Cambridge International as and a level Economics Ebook

The problem created by externalities
Th
e main problem created by externalities is that where they 
are present they will lead to an inappropriate amount being 
produced: the free market will lead either to too much or 
too little production. Th
is is an ineffi
cient use of resources.
Consider again a fi rm that produces a chemical. Th
ere 
are costs that the fi rm will have to meet in producing a 
certain quantity of this chemical. Th
ese would include 
such things as:
■ 
raw material costs
■ 
labour costs
■ 
energy costs
■ 
distribution costs, etc.
All such costs are termed private costs: they have to be paid 
for by the decision-maker (the fi rm). Th
ese costs form part 
of social costs. Th
ere are further costs likely to be involved 
as well. Th
ese might include the cost of dumping the 
chemical waste, perhaps unlawfully, in a local river, which 
in turn creates clean-up costs for a third party. In addition, 
any atmospheric pollution created might cause ill health 
for those living close to the factory and there is likely to be 
additional road congestion arising from the transportation 
of the chemicals. Th
ese are all negative externalities. 
social cost
cost of the negative externality
(external costs)
private cost
Figure 6.5
A diff erence between private and social costs
Social benefits:
 
the total benefits arising from a particular 
action.
Private benefits: 
benefits that accrue to individuals who 
produce or consume a particular good.
External benefits:
 
benefits that that are received by third 
parties not involved in the action.
KEY TERMS
136
Cambridge International A Level Economics

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Th
e problem is that only the private costs of producing and 
distributing the chemical will be taken into account by 
the fi rm when making its pricing decisions. Th
e external 
costs, which are 
the costs to society
, will not be taken into 
account. Th
is will mean that the price will be lower than 
if all social costs were recognised and taken into account. 
Consequently demand and production will be higher than 
if full social costs had been considered. Th
us, a negative 
externality will lead to overproduction. Th
e situation can 
be seen in 
Figure 6.6
.
Th
e price that will occur in the market will be 
P
1
where 
the supply schedule that takes account of the private 
costs, 
S
1
, is equal to demand. Th
is price is associated with 
production of 
Q
1
. However, if the supply schedule took 
into account the social costs, 
S
2
, which are greater than 
the private costs, then it would result in a price of 
P
2
. Th
is 
price is associated with a lower production of 
Q
2
. Th
us, the 
negative externality has led to 
Q
1 
−
Q
2
, overproduction. 
Too many scarce resources are being devoted to the 
production of this product. Th
e market has failed.
Th
e opposite problem is true of a positive externality. Here, 
the problem is that too little of the product is being produced. 
If only the private benefi ts are considered, there will be 
underproduction. Th
is situation is shown in 
Figure 6.7.
Th
is time, the problem is with demand. If only the 
private benefi ts are registered, then demand is represented 
by the demand schedule 
D
1
. Th
is leads to a price of 
P
1
and 
an associated production of 
Q
1
. However, if the further 
extra benefi ts to society were registered (which they will 
not be by the private decision-maker), then demand 
would be greater at 
D
2
. Th
is would lead to a price of 
P
2
and 
production of 
Q
2
. Th
us there is underproduction of 
Q
2
− 
Q
1
associated with the positive externality. Insuffi
cient scarce 
resources are being devoted to the production of this good 
or service. Th
e market has again failed.
Externalities are therefore a source of market failure 
as resources are not allocated in the ideal way: too few 
or too many resources are likely to be directed to the 
production of certain products.