Chapter 31, Problem 31.1LO

To determine

Answer to Problem 31.1LO

Private costs refer to the cost incurred by the firms in the production of goods and services. These costs include the direct costs the firm pays to purchase capital, labor, raw material, etc... used in the production of goods.

Social costs in addition to private costs also include cost to the society. Production of goods and services impose some external costs on the society. The external costs are included in the social cost.

Explanation of Solution

Private costs refer to the cost incurred by the firms in the production of goods and services. These costs include the direct costs the firm pays to purchase capital, labor, raw material, etc.… used in the production of goods.

While, social costs in addition to private costs also include cost to the society. Production of goods and services impose some external costs on the society. The external costs are included in the social cost.

$\text{Social Cost=Private Cost+External Cost}$.

Market externality occurs when the process of production imposes an external cost on the society. These externalities can be positive or negative.

a. Positive externalities occur when the process of production benefits others, but the producers are not compensated for these external benefits. In this case, social marginal cost is less than private cost by the amount of the marginal benefit.

b. Negative externalities occur when the process of production causes damage to the society in the form of pollution. The producers are not charged for these damages. In case of negative externality, social cost is higher than private marginal costs.

The following methods can be used to correct for externalities:

a. Pigouvian Tax/Subsidy.

b. Assigning property rights.

Economics Concept Introduction

Introduction:

Externality occurs when the action of one economic agent tends to affect the action of the other economic agent. For instance, when someone sitting next to you smokes. The smoke emitted by him will cause a problem to you. But this will not matter to him as he is gaining utility from smoking and does not bear any cost for the smoke.