Economics 9708/33 — October/November 2020

Background Concept

Externalities occur when the production or consumption of a good affects a third party not directly involved in the market transaction. These effects can be positive (benefits) or negative (costs). The social cost includes both the private cost borne by the producer and the external cost imposed on others. Similarly, social benefit includes private benefit and external benefit. The key formulas are:

• Marginal Social Cost (MSC) = Marginal Private Cost (MPC) + Marginal External Cost (MEC)
• Marginal Social Benefit (MSB) = Marginal Private Benefit (MPB) + Marginal External Benefit (MEB)

Understanding the Question

The question asks which statement is correct among four options that mix these formulas. It tests whether you know the correct relationship between private, external, and social costs/benefits. Option B correctly states that marginal social cost equals marginal private cost plus marginal external cost.

Approach

Recall the standard definitions of MSC and MSB. Then evaluate each option by comparing it to the correct formulas.

Step-by-Step Reasoning

• Option A: "marginal social benefit = marginal private benefit – marginal external benefit". This is incorrect because MSB = MPB + MEB, not minus. A positive externality adds to social benefit, so it should be added.
• Option B: "marginal social cost = marginal private cost + marginal external cost". This matches the definition exactly. Correct.
• Option C: "negative externality = marginal social benefit – marginal social cost". This is not a definition of a negative externality. A negative externality is an external cost, not the difference between MSB and MSC. The difference between MSB and MSC is the net social benefit, not the externality itself.
• Option D: "positive externality = marginal private benefit". This is incorrect because a positive externality is an external benefit, not the private benefit. The external benefit is the difference between MSB and MPB.

Thus, only option B is correct.

Key Takeaways

• MSC = MPC + MEC
• MSB = MPB + MEB
• External costs and benefits are added to private costs/benefits to get social costs/benefits.

Common Mistakes

• Confusing the sign: thinking external costs are subtracted rather than added.
• Mixing up cost and benefit formulas.
• Thinking that a negative externality is defined as MSB – MSC (that is the net social benefit, which could be negative if costs exceed benefits, but it is not the definition of the externality itself).

Things to Be Careful About

• Always add external costs to private costs to get social costs.
• Always add external benefits to private benefits to get social benefits.
• The term "marginal" means per unit, so these are per-unit measures.