Social costs and social benefits are based on external costs and benefits.
Private costs + External costs = Social costs
Private benefits + External benefits = Social benefits
Only private costs and private benefits are taken into account in a market economy.
The decisions taken on the production and consumption of goods and services are not optimum decisions as externalities are not taken into consideration.
This situation is illustrated by the following graph:
According to graph the equilibrium point (optimum point) is at point “A” where MSC is equal to MPB. Equilibrium (optimum) quantity produced and consumed is Q0.
But when the social benefits are taken into account optimum equilibrium point is at point “B” where MSC is equal to MSB. Q1 is the equilibrium production and consumption point.
When there is a positive externality of consumption, optimum consumption exceeds optimum market consumption when social benefits are less.
According to graph optimum market production is at “A” where MC is equal to MSB. Q0 is the equilibrium and optimum level of production.
When Social benefits are considered, optimum production is at “B” where MSC = MSB Q1 is the equilibrium and optimum production point.
When there is a positive externality of production and social benefits are taken into account, optimum production exceeds the optimum market production.
Following steps can be taken to prevent ill effects caused by externalities:
