KS4. Externalities and Cost-Benefit Analysis

Introductory Task


For market prices to effectively guide the allocation of resources in society, they must reflect the full costs and benefits associated with market transactions. Sometimes, however, they don’t, and there are costs and benefits external to the market in which they operate. In such cases, government intervention may be justified.

Market Failure

If the free market mechanism fails to lead to an optimal allocation of resources, for instance if there is a divergence between marginal social benefit and marginal social cost, we say that there is market failure. Examples of market failure include the fact that due to the free-rider problem the free market is unlikely to supply an adequate quantity of public goods.

The effective working of a market also relies upon consumers and producers having full and accurate information about the price and quality of goods available. In practice there is often asymmetric information, with some participants in a market being better informed than others.

A good example of asymmetric information is when you take your car for a service – it is unlikely that you know as much as the mechanic about cars, so if he tells you that you need to pay for a new carburettor it is hard to evaluate his claim (without employing the services of another mechanic.

If one firm becomes dominant in a market they can impose conditions on their customers or suppliers which their customers or suppliers have no choice but to accept in order to stay in the market, effectively due to lack of competition. This is also a kind of market failure.



Externalities are costs or benefits that are external to a market transaction and so are not reflected in market prices. This means that they are experienced by people not directly involved in the transaction and can lead to a form of market failure.

If part of the cost of a product is not felt by producers, they will produce too much of the good. If they don’t experience some of the benefits, they will produce too little.

A consumption externality affects the consumption side of a market, whereas a production externality affects the production side of a market. Both types of externality may be positive or negative.


When there are production externalities, the private costs incurred by a firm (on which it makes its production decisions) are accompanied by external costs incurred by a third party. We call the sum of these two costs the social cost.

In the above graph, we are assuming a competitive market, and so D, the demand curve, represents consumers willingness to pay for a good, and so reflects their marginal valuation of the good. The MPC line shows the marginal private costs faced by producers, whereas the S or MSC line shows the overall social cost of production. As can be seen the price set by the producer, P1, is lower than the equilibrium price and so more than the required amount of goods are produced. There is a divergence between the price in the market and the “true” marginal cost, i.e. a divergence between marginal social benefit and marginal social cost. This divergence is at the heart of market failure, because the last unit of the good sold imposes higher costs on society than the benefits society gets from consuming it.

Considering the consumption side, a private benefit is a benefit incurred by an individual due to participating in a transaction, and external benefit is a benefit incurred by a third party because of the execution of the transaction and the social benefit is the sum of the two.

An example of a positive consumption externality is personal improvements to properties, because these create a nicer environment for passers-by who do not incur any charge for the house improvements. This is demonstrated on the graph below:

Due to the position of the marginal private benefits curve to the left of the marginal social benefits curve, the amount of decoration arranged is less than the optimum level that would provide the greater benefit to society, i.e. Q*. Clearly in this instance there is something of a normative judgement rather than a positive statement, because views will differ on the ideal level of house decoration.

Below we consider a production externality with positive effects, efforts taken by a chemical form to purify their waste water and the positive impact this could have on a nearby fish farm.

Here we see that the marginal private costs lead to too little of the product being produced (i.e. it would be optimal for society if even more water was purified). The triangle represents the extent of the inefficiency.

Finally we consider a negative consumption externality, the effect of an individual listening to loud music in their apartment. The triangle below shows the cost to society due to the amount of music consumed being at level Q1 instead of Q*.

(N.B. The x-axis above should be labelled “Quantity of music listened to” and not “Number of journeys per period”. It will be relabelled and updated on this website soon.)

Some typical examples of externalities

Environment – e.g. emissions of toxins, climate change.

These issues can sometimes be particularly difficult because they are international, so they rely on coordination between different countries who may have different priorities, different capacities, and be affected to a different extent by the impact of climate change, say. International meetings have been held during the last 30 years at Kyoto and then at Paris to try to agree reductions in emissions to help reduce climate change, but few countries have implemented in line with their promises.

Another interesting environmental issue relates to the use of rivers. Excessive use of rivers by a country upstream of another country (e.g. by installing hydroelectric dams) can impact on industries relying on the river further downstream (this has often been an important political question between Egypt and Sudan).

Biodiversity is also an environmental issue with international relevance.

Transport – When the number of road users increases, this causes congestion, affecting all road users.

Health – In the case of an epidemic, an individual’s private health decisions, such as whether or not to get vaccinated, can impact on society as a whole.

Education – As well as education giving an individual a private benefit (e.g. greater career opportunities and life satisfaction), there is evidence that society enjoys greater benefits beyond that experienced by the individual, due to greater productivity at a group level, beyond the private improvements. This is another example of a positive consumption externality.

Tourism – Development of tourist infrastructure and benefit local businesses. It can also be argued that this can have a negative effect, where it leads to an imbalance in society (e.g. luxury hotels in close proximity to areas where people are experiencing poverty).

Summary of Types of Externality (ensure you know one example of each type)


For each of the categories above, as a group find three more examples of it.

Externalities Task 1

Externalities Task 2

Social Cost-Benefit Analysis

A social cost-benefit analysis is a process of evaluating the value of a project by comparing its costs and benefits, including both private and external costs and benefits. It involves 3 steps:

1.) Identify relevant costs and benefits: Direct costs such as labour costs and production costs are typically easy to identify. Indirect costs are harder to identify. These include opportunity costs and impacts on third parties.

2.) Valuation: In order to compare costs and benefits they should be given a monetary valuation. This can be difficult with external costs, which can be hard to measure exactly – we assign these a shadow price.

3.) Discounting the future: Where costs (or benefits) are felt in the future we apply a discount to reflect their value in the present, hence calculating the net present value (NPV) of the future stream of costs and benefits associated with the project being considered.

This kind of analysis provides a framework to help decision making. Of course it involves a lot of subjectivity and so whilst it may be helpful for ranking alternative projects based on their benefit-cost ratio, it should not be considered as definitive in decision making.

Advantages and Disadvantages of Cost Benefit Analysis

Task – Cost Benefit Analysis

Final Task

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