Externalities exist when there is a divergence between private and social costs and benefits
An externality occurs when a transaction affects someone outside it. The cost or benefit felt by that third party is not reflected in the market price.
Formula
MSC = MPC + External Cost; MSB = MPB + External Benefit
Real World
When a coal power station in the UK burns fuel to generate electricity, it emits CO₂ — a cost borne by the wider society through climate change that is not reflected in the electricity price consumers pay.
Exam Focus
Always label your externality diagram axes correctly: price/cost on the y-axis, and explicitly show the wedge between MPC and MSC (or MPB and MSB).
Price Elasticity of Demand
PED = % change in quantity demanded ÷ % change in price
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