Economics 9708/33 — May/June 2017

Background Concept

In welfare economics, the cost of an activity (e.g., producing a good) can be split into:

• Private cost: the cost borne directly by the producer (e.g., raw materials, labour).
• External cost: the cost imposed on third parties not involved in the transaction (e.g., pollution, congestion).
• Social cost: the total cost to society = private cost + external cost.

Similarly, benefits are divided into private, external, and social benefit. An external cost (a negative externality) exists when social cost exceeds private cost, i.e., the third parties bear extra cost. The mathematical relation is:

External cost = Social cost − Private cost

Thus a positive external cost corresponds to Social cost > Private cost, i.e., Social cost − Private cost > 0.

Understanding the Question

The question asks: When will an economic activity create an external cost? It presents four options that involve taking differences between social cost and private cost (options A and B) or between social cost and social benefit (options C and D). The correct answer must directly align with the definition that an external cost is the part of social cost that is not internalised by the private agent.

Approach

Recall the fundamental identity: Social cost = Private cost + External cost. Rearranging, External cost = Social cost − Private cost. Therefore, for an external cost to exist, Social cost − Private cost must be positive. Compare each option against this identity.

Step-by-Step Reasoning

1. Option A: Social cost minus private cost is negative. That would imply Private cost > Social cost, which is impossible because social cost includes private cost plus any external cost. A negative difference would indicate an external benefit (social cost less than private cost?), but that is not an external cost. So A is incorrect.

2. Option B: Social cost minus private cost is positive. This exactly matches the definition: if social cost exceeds private cost, the positive difference is the external cost. The activity imposes a net external cost on third parties. Correct.

3. Option C: Social cost minus social benefit is negative. That measure relates to net social welfare (if social cost < social benefit, the activity yields a net social benefit, not an external cost). External cost is defined purely in terms of costs, not benefits, so this is irrelevant.

4. Option D: Social cost minus social benefit is positive. This tells us the activity generates a net social cost (inefficiency), but does not directly measure external cost. An activity could have a net social cost even without externalities (e.g., private costs exceed private benefits). The question specifically asks for the condition for an external cost, not net social cost.

Thus only option B correctly identifies the condition.

Key Takeaways

• The core definition: External cost = Social cost − Private cost.
• External cost is a cost spill-over on third parties; it is not about total social benefit.
• Distinguish between external cost (a measure of a specific type of market failure) and net social cost (which could arise from other reasons).

Common Mistakes

• Confusing external cost with net social cost. Many students incorrectly choose D because a positive social cost minus social benefit indicates a harmful activity, but that is not the definition of external cost.
• Thinking of external cost as when private cost exceeds social cost (option A), which is impossible and would actually represent an external benefit.
• Overcomplicating with diagrams – this is a straightforward definition question.

Things to Be Careful About

• The formula is absolute: external cost is the difference between social and private cost, always positive for an external cost.
• Don't mix up with external benefit (which is social benefit − private benefit).
• The question does not ask about the overall desirability of the activity, only the condition for the existence of an external cost.