Study Notes
Positive and negative externalities occur when the actions of individuals or firms have unintended side effects on third parties, leading to market failure.
- Private benefit — the gain received by a producer or consumer involved in the production or consumption of a product. Example: A company profits from selling a product.
- External benefit — the gain to the rest of society not involved in the decision of production or consumption of a good. Example: Vaccinations provide herd immunity.
- Social benefit — the total benefit enjoyed by the decision maker and third parties. Example: Education increases productivity and reduces crime.
- Private cost — the expense borne by a producer or consumer involved in the production or consumption of a product. Example: A factory pays for raw materials.
- External cost — the expense to the rest of society not involved in the decision of production or consumption of a good. Example: Pollution from a factory affects nearby residents.
- Social cost — the total cost borne by the decision maker and third parties. Example: Fast fashion leads to environmental damage and labor exploitation.
Exam Tips
Key Definitions to Remember
- Private benefit
- External benefit
- Social benefit
- Private cost
- External cost
- Social cost
Common Confusions
- Confusing private benefits with social benefits
- Misunderstanding the difference between external and social costs
Typical Exam Questions
- What is an external benefit? An external benefit is a gain to society from a product or service not directly involved in its production or consumption.
- How do negative externalities lead to market failure? Negative externalities result in overproduction or overconsumption, causing a welfare loss.
- What is the difference between private and social costs? Private costs are borne by the producer or consumer, while social costs include external costs to society.
What Examiners Usually Test
- Ability to distinguish between different types of benefits and costs
- Understanding of how externalities cause market failure
- Use of diagrams to illustrate externalities and market failure