Answer to Question #196135 in Microeconomics for thhh

Question

Use the diagram above to explain what is meant by the term ‘external costs of production’, and use a suitable example to explain why these external costs will result in inefficient output being produced.

Answer 1

External cost refer to cost that are not paid directly by the producer . They are the cost related to delivery of the good or service.

The above diagram shows how the existence of external costs causes greater social marginal cost than the private marginal cost.

In a free market, there is overconsumption of the good (Q1). Social efficiency will occur at Q2 where SMC = SMB

Example of External Cost

By driving a car, private cost is imposed on the driver (i.e cost of petrol, tax and buying car).

On the other hand, by driving a car costs are incurred by other people in society. These can include:

Traffic and slower journey periods for other drivers.

Accidents cause death for pedestrians, cyclists and other road users.

Pollution, health-related problems and

Noise pollution

External costs will result in inefficient output being produced because free market ignores their existence. They do not involve the external cost in their economic transaction. The resulting wedge between social and private cost lead to inefficiency in the market.