Cambridge International as and a level Economics Ebook

Equilibrium and eff iciency: 
A market is not eff icient 
where there are externalities present; whether a market 
remains ineff icient can be the consequence of the actions 
taken to combat market failure. These actions are likely to 
change over time.
KEY CONCEPT LINK
TOP TIP
Externalities can arise through the actions of consumers 
as well as producers; at times the distinction is not 
always clear.
Externalities and ineff icient resource 
allocation
Private, external and social costs
Another way of understanding a negative externality is to 
defi ne it as any situation where there is a divergence between 
the 
private costs
and 
social costs
of an action. Th
e private 
costs are those costs that are paid for by someone who 
produces a good or service. Th
e social costs are the total 
costs to society of this production. If there is no externality, 
there is no diff erence between private costs and social costs 
and so there is an effi
cient allocation of resources. When 
there is a negative externality, the costs borne and paid for by 
third parties are known as 
external costs
.
Th
erefore, social costs 
=
private costs 
+
external costs. 
Social costs: 
the total costs of a particular action.
Private costs:
 
those costs that are incurred by
 
an 
individual who produces a good or service.
External costs:
 
those costs incurred and paid for by third 
parties not involved in the action.
KEY TERMS
It is quite possible that these private and social costs 
are the same: in other words, all of the costs of an 
action accrue to the individual or fi rm. If this is the 
case, then there are no externalities. However, it is also 
possible that there will be a diff erence: private and social 
costs may not be equal to each other. For example, if 
you make a decision to take a journey by car, you 
consider only the costs of the petrol and the time taken.