Pearson Edexcel · A-Level · Economics B
Course version: 9EB0 · Version from Sept 2015
A) Private costs, external costs and social costs
Full specification wording
Market failure and externalities: a) Private costs, external costs and social costs
Understanding the full cost of an economic activity requires distinguishing between private, external, and social costs.
Checked against the Pearson Edexcel 9EB0 specification (opens in a new tab) on .
- Point 1 of 5
- 4 key terms
Study notes
From the checked teaching notes for this specification point.
The idea
Understanding the full cost of an economic activity requires distinguishing between private, external, and social costs. Private costs are the direct financial costs borne by the producer or consumer, such as a factory paying for raw materials. External costs (negative externalities) are the uncompensated negative impacts on third parties outside the transaction, like local residents suffering health issues from the factory's pollution. Social costs represent the total cost to society, calculated as the sum of private costs and external costs. When external costs exist, the free market fails to allocate resources efficiently, leading to overproduction because the producer ignores the external costs, resulting in market failure.
What earns the marks
- Define private costs as the costs internal to a transaction borne by the producer or consumer.
- Define external costs as the negative spillover effects on third parties not involved in the transaction.
- State the relationship that social costs equal private costs plus external costs.
- Explain how the existence of external costs leads to market failure through overproduction and misallocation of resources.
Common mistakes and how to put them right
Confusing private costs with social costs.
Put it right: Social costs include both private costs and external costs; they are only equal if there are no external costs.
Assuming external costs are paid by the government.
Put it right: External costs are borne by third parties, such as society suffering from pollution, and are not necessarily paid for financially by anyone unless regulated.
Stating that market failure occurs because private costs are too high.
Put it right: Market failure occurs because the price mechanism ignores external costs, leading to overproduction of goods with negative externalities.
Exam tips
- Always use the relationship that social costs equal private costs plus external costs to structure your definitions and explanations.
- Provide a clear, concrete example of a third party when explaining external costs, such as a local community affected by noise pollution.
- When analysing market failure, explicitly state that the free market over-allocates resources to goods with external costs.
Try the lesson
The start of the Market failure and externalities: a) Private costs, external costs and social costs lesson, made from checked teaching notes for this specification point.
Have a go first
Which of the following best defines the social cost of a production process?
Listen
Understanding the full cost of an economic activity requires distinguishing between private, external, and social costs. Private costs are the direct financial costs borne by the producer or consumer, such as a factory paying for raw materials. External costs (negative externalities) are the uncompensated negative impacts on third parties outside the transaction, like local residents suffering health issues from the factory's pollution. Social costs represent the total cost to society, calculated as the sum of private costs and external costs. When external costs exist, the free market fails to allocate resources efficiently, leading to overproduction because the producer ignores the external costs, resulting in market failure. A strong answer earns marks for these points. Define private costs as the costs internal to a transaction borne by the producer or consumer. Define external costs as the negative spillover effects on third parties not involved in the transaction. State the relationship that social costs equal private costs plus external costs. Explain how the existence of external costs leads to market failure through overproduction and misallocation of resources. A common slip: Confusing private costs with social costs. Instead, social costs include both private costs and external costs; they are only equal if there are no external costs. Exam tip: Always use the relationship that social costs equal private costs plus external costs to structure your definitions and explanations.
See it
Key words
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Private costs
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External costs
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Social costs
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Market failure
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See every definition
- Private costs
- The costs internal to a transaction borne by the producer or consumer.
- External costs
- The negative spillover effects on third parties not involved in the transaction.
- Social costs
- The total cost to society, calculated as the sum of private costs and external costs.
- Market failure
- When external costs exist, the free market fails to allocate resources efficiently, leading to overproduction because the producer ignores the external costs.
Label the diagram
Some boxes have lost their names. Pick the right name for each number.
1Box 1
2Box 2
3Box 3
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