Economics 9708/32 — May/June 2022

Background Concept

In economics, an externality is a cost or benefit arising from a production or consumption activity that affects a third party who did not choose to be involved in that activity. External costs (negative externalities) are uncompensated costs imposed on others. For example, pollution from a factory imposes health and cleaning costs on local residents. These costs are a form of market failure because the private producer does not take them into account, leading to an overallocation of resources to the polluting industry.

The total social cost (SC) is the sum of private cost (PC) and external cost (EC):

SC = PC + EC

Private costs are the costs borne directly by the producer (e.g. fuel, labour, machinery). External costs are borne by society at large – individuals, other businesses, or the environment – and are not reflected in the market price.

Understanding the Question

The question asks: "Who bears these external costs?" It identifies "the generation of electricity" as an activity that causes external costs. The options list four possible bearers: distributors, the electricity company, the government (via subsidies), or local residents. The key distinction is between private costs (borne by the firm or its direct transactors) and external costs (borne by third parties).

Approach

Read each option carefully and apply the definition of an external cost. The people living in the area are the most obvious third party: they suffer from pollution, noise, or health effects. The distributors and the electricity company are direct participants. A subsidising government may incur a public cost, but that is not an "external cost" in the standard sense. Evaluate each against the definition.

Step-by-Step Reasoning

1. Option A: the distributors who sell the electricity
   Distributors are part of the supply chain. They pay for the electricity they buy and sell it to consumers. Any costs they incur (transmission, billing) are private costs, borne by the business. They are not external to the transaction.

2. Option B: the electricity company that produces the electricity
   This company bears its private production costs – fuel, labour, equipment, maintenance. Those are internalised in its profit calculations. External costs are those NOT borne by the producer, so this option is incorrect.

3. Option C: the government that subsidises the production of electricity
   A subsidy reduces the producer's private cost, but the cost of the subsidy is borne by taxpayers. This is a transfer, not an external cost. External costs arise from the activity itself (e.g. pollution), not from a government policy response.

4. Option D: the people living in the area where the electricity is generated
   These individuals are not party to the electricity transaction. They suffer from negative externalities such as air pollution, noise, and potential health impacts. They bear the external costs directly. This matches the definition.

Therefore, option D is correct.

Key Takeaways

• An external cost (negative externality) is a cost imposed on a third party outside the market transaction.
• The producer bears private costs; external costs are borne by others (usually the community, environment, or other firms).
• Government subsidies are a policy tool, not an external cost.

Common Mistakes

• Confusing private costs with external costs – thinking that because the producer causes pollution, the producer bears the cost. In reality, the producer may not pay for damage to health or the environment unless forced to (e.g. by regulation).
• Misinterpreting 'external' as 'outside the country' rather than 'outside the transaction'.

Things to Be Careful About

• The definition of an externality focuses on third parties who are not involved in the transaction.
• The electricity company's cost of subsidised inputs is still a private cost; the subsidy lowers it but does not make it an external cost.