Private costs and benefits, externalities and social costs and benefits

Economics A2 · The price system and the microeconomy. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Private costs and benefits fall on the buyers and sellers who make a decision. An externality is a cost or benefit that falls on a third party and is not paid for through the market. Social cost and social benefit include everyone.

Markets look only at private costs and benefits. With a negative externality, too much is produced or consumed. With a positive externality, too little is. In both cases output differs from the social optimum, where marginal social benefit equals marginal social cost, and there is a deadweight welfare loss.

Markets also fail when one side knows more than the other (asymmetric information). Moral hazard is when people take more risk because someone else bears the cost.

Rules to remember

Social cost = private cost + external cost (MSC = MPC + MEC).
Social benefit = private benefit + external benefit (MSB = MPB + MEB).
Free market output: MPB = MPC. Socially optimal output: MSB = MSC.
Negative production externality: MSC is above MPC, so the good is overproduced. Negative consumption externality: MSB is below MPB, so it is overconsumed.
Positive production externality: MSC is below MPC. Positive consumption externality: MSB is above MPB. The good is underproduced or underconsumed.
Deadweight welfare loss: the triangle between MSB and MSC, from the market output to the social optimum. Area = ½ × base × height.
Cost-benefit analysis: go ahead if total social benefit is greater than total social cost.

Common mistake

Students treat social cost as the external cost only. Social cost is the private cost plus the external cost.

Worked example

In a market, marginal private benefit is P = 80 − Q. Each unit consumed gives a constant external benefit of $12. Marginal private cost equals marginal social cost: P = 20 + Q. What is the deadweight welfare loss in a free market?

Free market output (MPB = MPC): 80 − Q = 20 + Q, so Q = 30.
MSB = MPB + 12 = 92 − Q. Social optimum (MSB = MSC): 92 − Q = 20 + Q, so Q = 36.
At Q = 30, MSB is 62 and MSC is 50, a gap of $12. The gap falls to zero at Q = 36.
Triangle area = ½ × (36 − 30) × 12 = 36.

Answer: The deadweight welfare loss is $36, caused by underconsumption of 6 units.

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