- Negative externality
- A negative externality is a cost that an exchange between a buyer and a seller imposes on a third party who is not part of the exchange.
- Positive externality
- A positive externality is a benefit that an exchange between a buyer and a seller brings to a third party who does not pay for it.
Private, external and social cost
Can you name the three kinds of cost on an externality diagram?
On the diagram, private and social cost are curves, and external cost is the gap between them.
Private costs are the costs of production that a firm itself incurs and pays, such as its labour and material costs.
Can you think of an example?
The last fridge the free market makes costs its maker £650 in labour, parts and materials. Market supply is the marginal private cost (MPC) curve.
External costs are the costs of production that fall on third parties, unpaid by the firm; per unit, they are the gap between MSC and MPC.
Can you think of an example?
Pollution from making each fridge does £100 of damage to people living near the factories. The makers pay none of it, so none of it shows in the price.
Social costs are the full costs of production to society: the private costs a firm incurs plus the external costs that pass on to others.
Can you think of an example?
The last fridge the free market makes costs its maker £650 and does £100 of damage, so its social cost is £750. Buyers value it at only £650, so society loses £100 on that fridge.