Private costs + External costs = Social costs
The private costs are those costs that are paid for by someone who produces or consumes a good or service.
For example, the driver of a car pays for the insurance, road tax, petrol and the cost of purchasing the car.
The external costs are the negative side-effects of production or consumption incurred by third parties, for which no compensation is paid.
For example, a car driver does not pay for the cost of the congestion and air pollution created when driving the car.
The social costs are the total costs to society.
The true cost of a car journey is called the social cost.
There is a market failure because the private costs (of driving) do not represent the true costs (of driving) to society.
Private benefits + external benefits = Social benefits
The private benefits are those that accrue solely to the individual making the action.
When a person has a vaccination against tuberculosis, they receive the private benefit of being immune to the disease.
External benefits are the positive side-effects of production or consumption incurred by third parties.
When a person has a vaccination against tuberculosis, other people are also protected from this highly contagious disease.
The social benefits of a decision are all of the benefits that accrue from that decision.
The true benefit of the vaccination is called the social benefit.
This is an example of market failure because there are external benefits to society of vaccination programmes. If vaccinations were left to the choice of individuals, they would be under-consumed, mainly due to the price that would be charged for them.
Marginal private benefit = Marginal private cost
The demand curve represents the benefits that consumers derive from consuming a good as measured by the prices they are willing to pay. For this reason, the demand curve is also known as the marginal private benefit (MPB) curve.
The supply curve shows the firm's costs of production; these are marginal costs, hence the supply curve is also known as the marginal private cost (MPC) curve.
Allocative efficiency (no externalities)
If there are no externalities present, then the best outcome is at price Pe and output Qe. Any variation from this optimum will be a situation of market failure or allocative inefficiency.
Social benefit maximisation which maximises the public interest or the welfare of the whole society occurs when:
Marginal social benefit (MSB) = Marginal social cost (MSC)
Social benefit is defined by the private benefit plus external benefit:
marginal social benefit (MSB) = marginal private benefit (MPB) + marginal external benefit (MEB)
Social cost is defined by the private cost plus external cost:
marginal social cost (MSC) = marginal private cost (MPC) + marginal external cost (MEC)