External Costs of Production (Edexcel IGCSE Economics)

Negative Externalities of Production

Spec point — 1.1.6a

• Whenever the production of a good or service generates external costs, it is referred to as a negative externality of production

  • External cost = social cost - private cost

• The market is failing due to over-provision of these goods and services, as only the private costs are considered by the producers and not the external costs

  • If the external costs were considered, the quantity of goods and services provided would decrease, and the remaining units would be sold at a higher price
  • Examples of external costs include pollution, congestion and environmental damage. These all have spillover effects on third parties

Diagram: Air Pollution from Production

External costs from factory include the effects of air pollution

• External costs can be observed in the steel industry

  • Steel firms create external costs to third parties not involved in the transaction between the firm and the buyer

    • They emit greenhouse gases into the air during the production process, which contributes to climate change
    • This pollution poses health risks, particularly affecting vulnerable groups such as children and those with respiratory diseases

• As a result os these external costs, the government may need to allocate additional funds for healthcare provision to address the health issues arising from pollution-related illnesses

The Impact of External Costs & Government Intervention

Spec point — 1.1.6b

• Analysing external costs and the government intervention necessary to correct them is best done by considering real world examples
• Analysis should always include the impact on stakeholders including producers, consumers, government, and relevant third parties

External Costs and Possible Government Intervention - Mining iron ore

Exam Hint Although this page focuses on external costs, you need to recognise that goods or services may also have benefits (e.g the steel industry has external costs but also provides employment opportunities, contributing to economic growth). The aim of government intervention should be to minimise external costs, while maximising the benefits the firm or industry offers.

You often be asked to define, give examples and formula for external costs.