Externalities

Edexcel BTheme 44.3.2 Updated

Written by — First-Class BSc (Hons) Economics, University of Bath · 6+ years teaching A-Level Economics · Edexcel A, Edexcel B, AQA and OCR

Specification Coverage: Edexcel B unit 4.3.2 - Externalities. Students need to use private, external and social costs and benefits, analyse the impact on society when prices leave out external costs, and apply this to environmental externalities.

Private, External and Social Costs and Benefits

The definitions are in unit 1.5.1. In short:

  • Social cost = private cost + external cost
  • Social benefit = private benefit + external benefit

A gas-fired power station is the example used on this page. Its private costs are gas, staff and equipment. Burning gas also releases carbon dioxide, which adds to climate change. That damage is an external cost: the people affected are not part of the deal between the power station and its customers, and are not compensated.

When Prices Leave Out External Costs

Internalising an externality: making the producer or consumer pay for the external cost, so it becomes part of their private cost and the price.

If the power station's price covers only its private costs, electricity sells for less than its full cost to society. Buyers respond to that low price, so more is produced than is best for society.

Diagram with Costs, Benefits on the vertical axis and Quantity on the horizontal axis. Demand is labelled D=MPB=MSB. The MSC curve lies above S=MPC. The market equilibrium is at P1 and Q1, where S=MPC crosses demand. The social optimum is at P2 and Q2, where MSC crosses demand, with Q2 less than Q1. A shaded triangle between Q2 and Q1 shows the welfare loss.
Figure 1: Prices that leave out an external cost. The market charges P1 and produces Q1. Charging the full social cost would raise the price to P2 and cut output to Q2

When prices do not reflect the full cost:

  • Over-production: the price is too low → demand is higher than it should be → output reaches Q1, above the social optimum Q2 → a welfare loss to society.
  • Third parties pay: the cost of the damage falls on people outside the market → through worse health, flood damage or clean-up bills → lower real incomes for people who gained nothing from the sale.
  • Clean firms lose out: a polluting firm's costs look lower than a clean rival's → it can charge less → the clean firm loses sales and has less reason to invest.
  • Wrong signals for investment: polluting methods stay cheap → firms keep using them → too little is spent on cleaner technology.

The same happens in reverse with external benefits. If buyers only pay for their private benefit, goods such as home insulation are under-consumed, and society misses out on gains it would value.

Environmental Externalities

Environmental externality: an external cost or benefit that affects the natural environment, such as air, water, land or the climate.

Air pollution, carbon emissions, sewage in rivers and waste in landfill are external costs. Planting trees, restoring wetlands and insulating homes create external benefits.

Diagram with Costs, Benefits on the vertical axis and Quantity on the horizontal axis. Supply is labelled S=MPC=MSC. The MSB curve lies above D=MPB. The market equilibrium is at P1 and Q1, where D=MPB crosses supply. The social optimum is at P2 and Q2, where MSB crosses supply, with Q2 greater than Q1. A shaded triangle between Q1 and Q2 shows the welfare loss.
Figure 2: Home insulation cuts energy use and emissions, an external benefit. Households consume Q1, less than the social optimum Q2

Environmental externalities are harder to correct because:

  • They are hard to measure: putting a money value on a damaged river or a warmer climate involves a lot of guesswork.
  • They cross borders: carbon emitted in one country warms the whole planet, so no single government can fix it.
  • They build up over time: much of the cost falls on future generations, who have no say in today's market.
  • Nobody owns the environment: with no owner to charge for its use, firms treat clean air and water as free.

The policies that try to internalise these costs, such as taxes and tradable pollution permits, are covered in unit 4.3.3.

Say who pays. The strongest answers on externalities name the third party who bears the external cost - residents near a factory, future generations - and explain why the price does not include it. Then use the diagram: the gap between MPC and MSC is the external cost of each unit, and the triangle is the welfare loss.

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