External costs and benefits Cambridge IGCSE Business Studies (9–1) revision
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In plain words
When a factory makes paint, it pays for workers and materials. But if its smoke makes the neighbours ill, they bear a cost too, and nobody pays them for it. A cost or benefit that falls on someone outside the deal is called external.
Markets ignore these spill-over effects, which is why they produce too much of some things and too little of others.
5 things to know
- Private costs are paid by the producer or consumer. External costs fall on third parties: pollution, noise, congestion, damage to the environment.
- Social cost = private cost + external cost.
- Private benefits go to the producer or consumer. External benefits go to third parties: a vaccinated person does not pass on a disease, and an educated workforce helps every firm.
- Social benefit = private benefit + external benefit.
- Goods with external costs are over-produced in a free market. Goods with external benefits are under-consumed.
Worked example
A journey by car has a private cost of $12 to the driver. The congestion and pollution it causes cost other people $5. What is the social cost?
- Social cost = private cost + external cost.
- Social cost = 12 + 5.
- Social cost = $17.
Tips and tricks
- A third party is someone who is neither the buyer nor the seller. Always say who the third party is in your example.
- Social means the total for society, not just the external part. Leaving out the private cost is the usual slip.
It lands in your notebook with its questions as flashcards.
External costs and benefits: 5 questions and answers
These are the quiz’s questions. Do the quiz first, then come back here for the ones that got you.
Which is an external cost of running a coal power station?
The forest owners are third parties. The others are costs the firm pays itself.
Social cost equals
Society's total cost is the firm's own cost plus the cost to others.
Which is an external benefit of a person having a flu vaccination?
The benefit goes to third parties.
A product has a private cost of $30 and a social cost of $42. What is the external cost?
External cost = social cost − private cost = 42 − 30.
In a free market, goods with external benefits tend to be
Buyers think only of their own benefit, so they buy less than is best for society.
Quiz
5 questions
Tap an answer and you’ll see straight away whether it’s right, and why.
Worksheet
3 questions, 7 marks. Write your answers on paper, then check them.
External costs and benefits
Cambridge IGCSE Business Studies (9–1) 0986 · 7 marks · papermunch.org
Name ______________________________ Date ______________
Define external cost.[2]
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A cost of production or consumption that falls on a third party, someone other than the producer or consumer.
The private benefit of a training course to a worker is $900 and the external benefit to others is $350. Calculate the social benefit.[2]
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$1250. Social benefit = 900 + 350.
Explain why a free market produces too many goods that have external costs.[3]
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Firms take account only of their private costs. The external costs are ignored, so the price is lower than the true cost to society and more is produced and consumed than is best for society.
Answers: External costs and benefits
- 1. A cost of production or consumption that falls on a third party, someone other than the producer or consumer.
- 2. $1250. Social benefit = 900 + 350.
- 3. Firms take account only of their private costs. The external costs are ignored, so the price is lower than the true cost to society and more is produced and consumed than is best for society.