Definition
An externality is a cost or benefit from production or consumption that falls on a third party who is not involved in the transaction.
- Negative externality — a cost to a third party (pollution, congestion, noise).
- Positive externality — a benefit to a third party (vaccination, education, training).
The important word is third party. If the cost or benefit falls only on the buyer and seller, it is not an externality.
The two key comparisons
| Type | Problem | Result |
|---|---|---|
| Negative externality | Social cost > private cost | Market overproduces |
| Positive externality | Social benefit > private benefit | Market underproduces |
Negative externality — the chain
A factory emits pollution that harms local residents. The firm pays only its private costs, such as labour and materials, so its marginal private cost is lower than the marginal social cost. Because it does not pay for the pollution, the firm produces at a lower cost and supplies more than the socially efficient quantity. At this output, the marginal social cost is greater than the marginal social benefit, so each extra unit creates a welfare loss. The result is a deadweight loss and an overallocation of resources to this industry.
Positive externality — the chain
Education creates benefits for society beyond the individual student, such as higher productivity and lower crime. The private benefit to the student is lower than the social benefit, so the student demands less education than is socially optimal. Because the market underprovides education, the marginal social benefit exceeds the marginal social cost at the free-market output. There is a welfare loss from underconsumption, and resources are underallocated to education.
The diagram
For a negative externality of production:
- Draw MPC upward sloping.
- Draw MSC above MPC (the vertical distance is the external cost).
- Draw MPB = MSB downward sloping.
- Mark free-market output where MPC = MPB.
- Mark socially efficient output where MSC = MSB.
- Shade the deadweight loss triangle between the two output levels.
For a positive externality, the logic is reversed: the social benefit curve is above the private benefit curve.
What earns marks
Examiners reward:
- Correct definitions of private and social cost/benefit.
- A clear statement of overproduction or underproduction.
- A chain that links the externality to the deadweight loss.
- Correct diagram labels and a reference to the shift or difference.
- Evaluation of the size or measurement of the externality.
What loses marks
- Saying "it harms people" without linking to cost. Explain the welfare loss.
- A diagram with no explanation. State what the diagram shows.
- Mixing up MPC and MSC. Get the direction right.
- Describing an externality as a cost to the firm. It falls on a third party.
- Ignoring the question's context. Use the market given.
Evaluation angles
- How large is the external cost, and can it be measured?
- Who exactly is affected, and how?
- Does the externality vary by location or time?
- Could intervention create a larger cost?
- Is the effect short run or long run?
Quick check
- Define a negative externality.
- Explain why a negative externality causes overproduction.
- Draw the diagram from memory.
- Explain one reason the deadweight loss might be small.