Study Notes
Externalities are costs or benefits that affect third parties who are not directly involved in an economic transaction. They can lead to market failure when the market does not allocate resources efficiently.
- External costs — negative side effects of production or consumption incurred by third parties where no compensation is paid.
Example: Air pollution, cigarette smoke, noise pollution. - External benefits — positive side effects of production or consumption experienced by third parties for which no money is paid by the beneficiary.
Example: A well-kept garden gives pleasure to neighbors. - Social costs — the full costs of consumption or production to society as a whole.
Example: Social costs = Private costs + External costs. - Social benefits — the full benefit of consumption or production enjoyed by society.
Example: Social benefits = Private benefits + External benefits. - Mixed economic system — a combination of both planned and market economy where both market forces and government intervention control the economic system.
Example: Government provides essential services to redistribute income and wealth.
Exam Tips
Key Definitions to Remember
- External costs
- External benefits
- Social costs
- Social benefits
- Mixed economic system
Common Confusions
- Confusing external costs with private costs
- Misunderstanding the role of government in a mixed economy
Typical Exam Questions
- What are external costs?
External costs are negative side effects of production or consumption incurred by third parties where no compensation is paid. - How do external benefits affect society?
External benefits are positive side effects of production or consumption experienced by third parties, enhancing overall societal welfare. - What is a mixed economic system?
A mixed economic system combines both planned and market economies, with government intervention and market forces controlling the economy.
What Examiners Usually Test
- Understanding of how externalities lead to market failure
- Ability to differentiate between private and social costs and benefits
- Knowledge of how governments can address externalities