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Externalities
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Sometimes a transaction affects people who are not part of it. These spillover effects are called externalities.
External costs
External costs of production are costs to third parties (people not involved in the transaction) that the producer does not pay.
Examples: pollution, congestion and environmental damage.
Examples: pollution, congestion and environmental damage.
External benefits
External benefits of consumption are benefits to third parties when a good is consumed.
Examples: education (a skilled workforce helps everyone), healthcare and vaccinations (vaccinated people protect others from disease).
Examples: education (a skilled workforce helps everyone), healthcare and vaccinations (vaccinated people protect others from disease).
Social costs and benefits
Social costs = private costs + external costs
Social benefits = private benefits + external benefits
With external costs, the market produces too much. With external benefits, the market consumes too little. Both are market failures.
Social benefits = private benefits + external benefits
With external costs, the market produces too much. With external benefits, the market consumes too little. Both are market failures.
A factory's private costs are £500 000 a year. The pollution it causes costs local people £150 000. What is the social cost?
- Social cost = private + external
- 500 000 + 150 000
Answer: £650 000
External costs fall on third parties (pollution, congestion). External benefits go to third parties (education, vaccinations). Social cost = private + external cost. Social benefit = private + external benefit.
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