An externality is a cost or benefit that lands on a third party. Draw the welfare loss triangle correctly and most of the marks follow.
Why is a cheap flight cheap?
An externality is a cost or benefit felt by someone who is not part of the transaction. The market ignores it, so output is wrong. Negative externalities cause overproduction, positive ones cause underproduction. The gap between private and social curves creates a welfare loss, which taxes, subsidies, permits or regulation try to remove.
An externality is a cost or benefit that falls on a third party, someone who is not the buyer or the seller. The price in the market does not include it.
Economists split externalities by direction and by source. That gives four cases.
| Type | Source | Example |
|---|---|---|
| Negative, production | Firm | A factory pollutes a river |
| Negative, consumption | Consumer | Car use causes congestion and fumes |
| Positive, production | Firm | A firm trains workers who later move jobs |
| Positive, consumption | Consumer | Vaccination lowers the risk for others |
Two sets of curves matter. Private costs and benefits are what the buyer and seller face. Social costs and benefits add the external part.
Society is best off where marginal social benefit equals marginal social cost. That is the socially optimal output. A free market settles where the private curves meet, so the two outputs differ.
Take a negative production externality. The firm pays only its private costs, so supply is the marginal private cost (MPC) curve. Society also bears pollution costs, so the marginal social cost (MSC) curve lies above it.
The market produces where demand meets MPC. At that quantity, MSC is higher than the marginal benefit, so the last units cost society more than they are worth. The market overproduces.
Illustrative figures: the external cost is £4 per unit at every output. The market produces 100 units, but the optimum is 80. The welfare loss is half × base × height, so ½ × 20 × £4 = £40.
For a positive externality the logic reverses. MSB lies above MPB, the market produces too little, and the triangle sits between the market output and the higher optimum.
The aim is to internalise the externality. That means making the decision-maker face the full social cost or benefit.
Real schemes show both the idea and the limits. London has charged drivers to enter its central zone since February 2003.[1] The UK Emissions Trading Scheme (UK ETS) has run since January 2021 as a cap-and-trade system. Air Passenger Duty is a per-passenger tax on flights leaving the UK, and its rate depends on distance and class.[3]
For evaluation, ask five questions. Can the external cost be measured, because a tax set too high or too low still leaves a loss? How elastic is demand, because inelastic demand means the tax cuts output very little? Who bears the tax, and is it regressive (taking a larger share of low incomes)? Can firms or drivers move elsewhere? Does the time lag matter, because benefits of a subsidy may appear years later?
Government failure is also a risk. Officials may set the wrong tax rate, or the revenue may not be spent on the problem.
One more habit helps. State the optimum quantity and the market quantity in words before you evaluate, so your argument is anchored to the diagram.
The economics is the same on every board; the question format is what changes. Most questions on this topic take one of six shapes. Open each to see how the topic appears in it and what earns the marks. All questions here are original Curriculum Circle practice questions, not board questions.
On this topicCommon. Expect definitions of externality and third party, and questions on which curve shifts for each type.
What earns the marksAO1 for definitions, with some AO2 when a short scenario must be classified.
CC practice questionA firm's factory causes smoke that harms nearby residents. This is an example of: A a positive consumption externality; B a negative production externality; C a merit good; D a public good. (1 mark)
On this topicFairly common. You may find the welfare loss from a triangle, or the tax needed to close the gap between MSC and MPC.
What earns the marksAO1 for the method and AO2 for applying it to the figures.
CC practice questionIllustrative figures: market output is 600 units and the optimum is 500. The external cost is £3 per unit. Calculate the welfare loss. (2 marks)
On this topicVery common. Explain why a market with an externality over- or under-produces, or why a subsidy helps.
What earns the marksAO1 for the definition, AO2 for the context and AO3 for the chain of reasoning.
CC practice questionExplain why vaccination may be under-consumed in a free market. (6 marks)
On this topicThe core of this topic. A diagram is nearly always expected, and the welfare loss triangle carries marks.
What earns the marksAO2 for applying to the case and AO3 for a developed, diagram-supported analysis.
CC practice questionUsing a diagram, analyse how a tax on plastic packaging could reduce the welfare loss from a negative externality. (9 marks)
On this topicCommon. Usually asks whether a tax, subsidy or regulation would work, using an extract on a charge or scheme.
What earns the marksAO1 to AO4, with most credit for AO3 analysis and AO4 judgement.
CC practice questionEvaluate the view that a congestion charge is the most effective way to deal with traffic externalities in a large city. (12 marks)
On this topicRegular. Essays ask whether intervention improves welfare, often asking you to weigh market failure against government failure.
What earns the marksAll four AOs. AO4, a supported judgement, decides the top band.
CC practice questionTo what extent can government intervention remove the welfare loss caused by negative externalities? (25 marks)
| Weight | What it is | What it means on externalities | |
|---|---|---|---|
| AO1 | 20–23% | Knowledge and understanding of terms, concepts, theories and models | Define externality, third party, MPC, MSC and welfare loss accurately, and name the four types. |
| AO2 | 26–29% | Application to economic contexts | Apply the idea to the context in the question, such as flights, traffic, education or vaccination, and use the figures given. |
| AO3 | 26–29% | Analysis of issues and their impact on economic agents | Build chains: price ignores external cost, so output is above the optimum, so there is a welfare loss, so a tax shifts MPC towards MSC. |
| AO4 | 22–25% | Evaluation, using evidence to reach a judgement | Weigh tools against each other, judge how far the external cost can be measured, and reach a conclusion about what the result depends on. |
Weightings are approximate and taken from the AQA A-level Economics 7136 specification [0]. Edexcel and IAL weight the objectives differently, but they test the same four skills.
Assess whether a tax on air travel is an effective way to deal with the externalities of flying.
Flying creates emissions that harm people who are not passengers. The airline and passenger pay only private costs, so supply is MPC and the market output is where D meets MPC. At that output, MSC is above the price, so output is higher than the social optimum and there is a welfare loss.
A per-passenger tax raises the airline's costs, so MPC shifts up towards MSC. Fares rise, so quantity demanded falls towards the optimum, and the welfare loss shrinks.
The tax works best if it is set close to the true external cost. That cost is hard to measure, so the rate is partly a political choice. If demand is price inelastic, such as for business travel, the tax raises revenue but cuts flights very little, so emissions fall less than hoped. A tax on departures may also push passengers to fly from airports abroad, which limits the gain. A cap-and-trade scheme fixes the quantity of emissions directly, which can be more certain than a tax. On balance, a tax is effective as part of a wider package if it is set near the external cost and demand is elastic. If the tax is small and demand is inelastic, its main effect is revenue, not a fall in the externality.
London introduced a congestion charge for driving in the central zone in February 2003. It prices the external cost of traffic by making drivers pay to enter.[1]
Air Passenger Duty (APD) is charged per passenger on flights leaving the UK. Its rate depends on distance and travel class, so it acts as a tax on a negative externality as well as a source of revenue.[3]
Everything above is the topic page. The pieces below take it further. Each one trains a particular assessment objective rather than covering the topic again, and they are added over the year.
Figures and facts were checked against these sources on 2 November 2026. Worked numbers labelled "Illustrative figures" are invented for teaching.
The CC Economics revision platform drills externality diagrams and calculations, and the Inner Academy covers the topic in recorded lessons.
See the Economics platformThe Inner Academy