external costs and external benefits of business decisions

6.2.3 External Costs and Benefits (Externalities)

Learning Objective

Explain how business decisions can create external costs (negative externalities) and external benefits (positive externalities), assess their impact on society and the market, and evaluate the role of government, ethical considerations and sustainable‑development goals in correcting market failure.

Key Definitions (Cambridge terminology)

• External Cost (Negative Externality): A cost imposed on a third party who is not part of the transaction.
• External Benefit (Positive Externality): A benefit received by a third party who is not part of the transaction.
• Social Cost: Private cost + External cost.
• Social Benefit: Private benefit + External benefit.
• Externality: The overall term for any external cost or benefit.
• Production Externality: Arises from the production process (e.g., factory pollution, over‑fishing).
• Consumption Externality: Arises from the consumption of a good or service (e.g., second‑hand smoke, traffic congestion).

Production vs. Consumption Externalities

Production externalities occur when the act of producing a good or service creates side‑effects for others. Examples: air‑pollution from a steel plant, water‑contamination from a textile factory, depletion of a fishery.

Consumption externalities occur when the act of consuming a good or service creates side‑effects for others. Examples: second‑hand smoke from cigarettes, noise from a night‑club, traffic congestion caused by a new shopping centre.

External Costs – Negative Externalities

These arise when production or consumption imposes unwanted side‑effects on people who are not directly involved.

• Air, water or noise pollution from factories (production).
• Traffic congestion and increased road wear caused by a new shopping centre (consumption).
• Health problems from second‑hand smoke (consumption).
• Depletion of non‑renewable resources such as over‑fishing (production).

Link to Sustainable Development

When firms internalise external costs they help achieve sustainable development by reducing environmental pressures, preserving natural resources and protecting the health of future generations.

Ethical Dimension

Example: A clothing manufacturer sources cheap fabric from a supplier that discharges untreated waste into a local river. The lower input cost raises profit, but the river‑pollution harms the surrounding community, raising ethical questions about environmental responsibility.

Stakeholder Impact (Negative Externalities)

Illustrative Calculation (Negative Externality)

Factory output: 1,000 units
Private cost per unit: $20
External (pollution) cost per unit: $5

Social Cost per unit = Private Cost + External Cost = $20 + $5 = $25

Total Social Cost = 1,000 × $25 = $25,000

External Benefits – Positive Externalities

These arise when production or consumption creates spill‑over advantages for third parties.

• Education – a more skilled workforce benefits employers and the wider economy (production).
• Vaccination programmes – reduce disease spread, protecting the whole community (consumption – service sector).
• Research & Development – innovations can be adopted by other firms (production).
• Public parks – improve mental health and increase nearby property values (consumption).

Link to Sustainable Development

Positive externalities such as renewable‑energy R&D, community training programmes or public‑health initiatives contribute to long‑term economic, social and environmental sustainability.

Ethical Dimension

Example: A tech company funds a local coding boot‑camp. Although the training costs the firm, it creates a skilled talent pool that benefits other businesses and reduces youth unemployment – an ethical contribution to the community.

Stakeholder Impact (Positive Externalities)

Illustrative Calculation (Positive Externality)

Company invests $10,000 in employee training.
Private benefit (higher productivity) = $8,000
External benefit to community (extra tax revenue, reduced unemployment) = $3,000

Social Benefit = Private Benefit + External Benefit = $8,000 + $3,000 = $11,000

Net Social Gain = Social Benefit – Cost = $11,000 – $10,000 = $1,000

Comparison: Private vs. Social Outcomes

Dead‑Weight Loss from Externalities

When the market ignores external costs or benefits, the equilibrium quantity (Q_m) differs from the socially optimal quantity (Q_opt). The area between the marginal social cost (or benefit) curve and the private marginal cost (or benefit) curve, over the range of production/consumption, represents a dead‑weight loss – a loss of total welfare.

Government Intervention to Correct Externalities

Cambridge expects at least three tools. All aim to internalise the externality so that private incentives align with social welfare.

1. Pigouvian Tax (or levy) – Raises the private cost to equal the social cost for negative externalities.
2. Subsidy – Raises the private benefit to equal the social benefit for positive externalities.
3. Regulation / Legislation – Directly sets limits (e.g., emission standards, bans on harmful substances).
4. Tradable Permits (Cap‑and‑Trade) – Allocates a fixed number of pollution rights, creating a market for the right to pollute.
5. Legal Controls – Enforcement of environmental law, health‑and‑safety statutes, or consumer‑protection rules.

Link to Other Functional Areas

• Marketing: Advertising a “green” product can generate a positive externality (environmental awareness) but may also involve “green‑washing,” an ethical issue.
• Operations / Production: Choice of raw materials, energy sources and waste‑management directly affect the magnitude of external costs.
• Finance: Environmental accounting, Social Return on Investment (SROI) and carbon‑pricing affect investment decisions.

Suggested Diagram (Supply‑and‑Demand)

• Private marginal cost (PMC) curve – upward sloping.
• Social marginal cost (SMC) curve – lies above PMC when a negative externality exists.
• Demand curve (marginal benefit) – downward sloping.
• Market equilibrium (Q_m, P_m) where PMC = Demand.
• Socially optimal equilibrium (Q_opt, P_opt) where SMC = Demand.
• Dead‑weight loss shown as the triangular area between PMC and SMC from Q_opt to Q_m.
• Effect of a Pigouvian tax: shifts PMC upward until it coincides with SMC, moving the outcome from Q_m to Q_opt.

Key Points to Remember

• Externalities cause market failure because market prices omit third‑party costs or benefits.
• Negative externalities → over‑production; positive externalities → under‑production.
• Government policies aim to internalise externalities, aligning private incentives with social welfare.
• Considering external costs/benefits is essential for ethical decision‑making and for meeting sustainable‑development goals.
• Businesses that recognise and manage externalities can improve reputation, avoid legal penalties and create long‑term value for shareholders and society alike.