PRIVATE COST, EXTERNAL COST AND

SOCIAL COST
 PRIVATE COST
When firms produce goods and services costs are
generated.
These are the costs of production, such as the cost of raw
material, rent, labour, tax and so on.
Each firm creates these costs when producing goods.
And these costs are PAID FOR BY THE FIRM.
Costs that are paid for by the firm are called PRIVATE
COSTS.
EXTERNAL COST
NEGATIVE SPILL OVER EFFECTS OF PRODUCTION.
When firms produce goods they can generate negative spill over effects.
For example a factory leaks harmful emissions, such as carbon, into the atmosphere
causing health problems. There are costs associated with this, such as the loss of
earnings through illness and the costs to the tax payer of treating the illnesses.
Production and other economic activities causes pollution that most scientists argue
has caused global warming and rising sea levels. This means that government will
have to spend resources on flood defences in certain areas. Productive land might be
taken by the sea leading to a fall in potential output and income. The damage to the
environment creates costs that must be paid by future generations.
These are examples of NEGATIVE EXTERNALTIES or EXTERNAL COSTS.
And these costs ARE NOT PAID BY THE FIRM.
External costs are paid by THIRD PARTIES - those who are outside of the market.
Often they are paid by the tax payer.
PRIVATE COST, EXTERNAL
COST AND SOCIAL COST
Firms are part of society therefore private costs form part
of social cost.
Third parties are part of society therefore external costs
form part of social cost.
Social cost is the sum of private costs and external costs:
Social cost = private costs + external costs.
Therefore, whenever negative externalities (external
costs) are generated by the production of output social
cost of production is greater than private cost.
 MARGINAL PRIVATE COST
In order to increase output firms must allocate more resources to the
production of the good. Therefore the costs of the resources used to make the
goods must increase. Thus as output rises total private cost increases.
Marginal private cost is the addition to total private cost from increasing
output by one unit.
MPC = the change in total private cost / the change in output
Therefore if output increases by one unit MPC = the increase in total private
cost / 1
Therefore Marginal private cost is the addition to total private cost from
increasing output by one unit.
As quantity of goods produced rises MPC rises. (I will explain why later in
the course)
 MARGINAL EXTERNAL COST
As output increases the total negative spill over effects/negative externalities/external costs from
production increases.
MEC = the change in total external costs / the change in output
If output increases by one unit MEC = the change in total external cost / 1
Then Marginal external cost is the addition to total external cost from increasing output by one
unit

Marginal social cost = marginal private cost + marginal external cost

Therefore the difference between MPC and MSC is MEC
Whenever negative externalities are created during production marginal social cost is greater than
marginal private cost at each level of output.
DIAGRAM SHOWING MPC AND MSC
In the diagram below it is assumed that MEC increase as output increases at a
constant rate. Hence the MEC curve is a horizontal straight line. It is assumed that
MPC increase at an increasing rate. MSC = MPC + MEC. Therefore at all levels of
output MSC > MPC. Therefore the MSC curve is above the MPC curve at all levels
of output.
The vertical distance between the MPC curve and the MSC curve is the value of
marginal external cost at each level of output. The MEC curve is not normally shown
on diagrams.
 HOMEWORK
Learn the meanings of: private cost, external cost, social cost, MPC, MEC, MSC
Answer the following essay question:
Explain why it might be the case that marginal social cost is greater than marginal private cost at
each level of output (10)
Remember:
Take time to research and structure your essay before you start writing thus ensuring that your
arguments follow a logical, coherent chain of reasoning.
Define the key terms
And write a few sentences at the end of your essay, in conclusion. Refer back to the question. E.g.
‘As I have explained above, MSC = MPC + MEC. Thus when negative externalities are generated in
the production process MSC will be greater than MPC at each and every level of output’.