0264 · 6.2.3External costs and benefits

Private, external and social effects

0:00A new factory brings changes far beyond its entrance gates. Its owners pay for machinery, but nearby residents experience the noise from deliveries. Local shops may gain customers when new employees buy their lunches. By the end of this video, you will understand how one business decision creates costs and benefits across the surrounding community. Start by separating the business itself from everyone affected around it. Private costs are the costs of a business decision paid by the business itself.

0:25Building premises, buying equipment and paying wages belong in this category. The business must find the money for these payments, so they affect whether its plans are affordable. Private benefits are the gains from a business decision received by the business itself. Revenue is the income a business receives from selling goods or services. Opening larger premises may allow more sales, which increases this income. Profit is total revenue minus total costs.

0:50These gains help explain why owners might want their business to expand. External costs are the costs of a business decision paid by the rest of society. People or organisations outside the business making the decision are called third parties. External costs fall on these third parties, and the business does not pay them. Payment can take the form of lost time, damaged surroundings or reduced wellbeing. Residents who lose sleep because of factory noise bear a cost even without receiving a bill.

1:16External benefits are the gains to the rest of society from a business decision. A new factory may provide jobs for local people or improve roads that other travellers can use. Nearby shops can gain customers, and training can improve employees’ skills. The central distinction is who receives the gain or bears the burden. A business can control a decision while its consequences reach people outside its accounts. Delivery schedules, for example, determine when lorries enter neighbouring streets.

1:43Residents may experience traffic delays, yet their lost time does not appear among the factory’s payments. This explains why looking at the business’s finances gives only part of the picture. Pollution, traffic congestion, noise and loss of open countryside are common external costs. Smoke can worsen the air that neighbours breathe, so their health suffers. Extra traffic increases journey times for other road users. Residents can lose sleep when machinery is noisy at night.

2:09Building over an open field removes space that the community previously enjoyed. The same activity can create separate costs for different groups. A business pays for its delivery vehicles, so that payment is a private cost. Other drivers bear the delays caused by those vehicles, so they carry an external cost. The total cost of a decision to society is called social cost, and it equals private cost plus external cost.

2:32Follow each effect to the person who bears it before choosing the correct category.

Classifying factory impacts

2:36Local jobs provide residents with opportunities to earn an income. A new road can shorten journeys for people travelling through the area. Nearby businesses benefit when additional customers spend money with them. Training gives employees skills they can use throughout their careers. Each benefit reaches someone beyond the business making the original decision. Some effects have both a private side and an external side. Training gives the business a private benefit when it helps employees produce more.

3:02Those employees also keep their new skills if they later move to other jobs. When a business pays for a new access road, that spending is a private cost. Other travellers gain an external benefit when they use the road for easier journeys. Redwood Engineering makes car parts and wants permission to build a factory near a town. Its plan includes local recruitment, employee training and a new access road available to everyone.

3:24Lorries would pass nearby houses with noise and exhaust fumes, and construction would cover an open field. Local shops expect additional customers from the new workplace. Begin with the costs that Redwood Engineering would pay directly. Construction, machinery and wages are private costs because the business funds them. Selling additional car parts would bring private benefits through increased revenue. Establishing this boundary helps us separate the owners’ financial interests from the effects on the wider town.

3:50Next, trace the consequences for nearby residents and other travellers. Lorry noise would disturb households along the delivery route, and the exhaust fumes would pollute their air. Extra vehicles could delay road users, while losing the field would reduce the community’s open space. These are external costs because the burden falls on third parties. Now follow the gains described in the plan. Local recruitment would give residents opportunities to earn wages.

4:14Shops could increase their sales when employees buy food and other items nearby. Training would improve employees’ skills, and the access road would help other travellers. These external benefits explain why some residents might welcome the proposal. Redwood Engineering will count only its private costs and benefits when it plans the factory. A government may consider both external costs and external benefits before granting permission, because it acts for the whole town.

4:39It needs information about the severity of noise, the likely traffic delays and the value of the lost field. The usefulness of the road and the scale of local recruitment also matter. Counting favourable and unfavourable points alone gives an incomplete judgement because their importance can differ greatly. The jobs, training and road would help many households for years, while the noise and fumes fall mainly on homes along one route.

5:01Moving the delivery route onto the new road, away from those houses, would cut the most serious external costs. The jobs and the shops’ extra customers would remain. A government could therefore give permission on the condition that lorries use the new road.

Answering external effects questions

5:14Keep the classification tied to each specific effect. Building expenditure is a private cost because the business pays it, while residents’ lost sleep is an external cost. Identify an external benefit by naming the group outside the business that gains. Also remember that time, health and access to open space can matter without a stated dollar value. In Paper One Short Answer and Data Response or Paper Two Case Study, stimulus material could describe a proposal like this.

5:40An exam-style question is, explain one external cost and one external benefit of the proposed factory. Explain means set out purposes or reasons, say why and how, supported with relevant evidence. Use details from the case to connect each effect with its consequence. Lorries passing nearby houses would create noise that disturbs residents’ sleep and reduces their wellbeing. This is an external cost borne by households around the delivery route.

6:04The new access road would improve journeys for other travellers in the town. This is an external benefit because third parties outside the business would gain from its construction. External costs are the costs of a business decision paid by the rest of society. For the positive effects, remember that external benefits are the gains to the rest of society from a business decision. Private effects fall within the business’s own costs and gains, and social cost is private cost plus external cost.

6:29Follow the decision beyond its entrance gates, identify the affected groups, and explain the consequences for each.