A private cost is a cost paid by the person or firm making a decision. An external cost is a cost that lands on someone else who had no say and is not paid for it. Add them together and you get the social cost.
This skill opens market failure concepts. Later lessons on under-consumption and policy comparison depend on it, so it pays to get the sorting right first.
How do you tell whose cost it is?
Ask two questions about every cost in the question.
- Who makes the decision? (the buyer, the seller or the producer)
- Who actually bears this cost?
If the answers are the same person, the cost is private. If a different person bears it and receives no payment, the cost is external. A cost to a third party that is fully compensated has been turned into a private cost of the producer, so it is no longer external.
The same event can create both. When a factory runs, its owner pays for dye and wages. People downstream may lose income because the river is spoiled.
Worked example: Harbour Dye Works
Harbour Dye Works is a fictional firm in the fictional town of Pelabuhan Teduh. In one month it dyes 500 rolls of cloth.
| Item | Who pays | Amount (RM) |
|---|---|---|
| Dye, chemicals and energy | Harbour Dye Works | 11,000 |
| Wages | Harbour Dye Works | 9,000 |
| River clean-up by the fishing village | Village households | 3,000 |
| Lost fish catch | Village households | 2,000 |
Step 1, private cost. The firm pays 11,000 + 9,000 = RM 20,000.
Step 2, external cost. The village bears 3,000 + 2,000 = RM 5,000. The firm pays none of it.
Step 3, social cost. 20,000 + 5,000 = RM 25,000.
Step 4, per roll. Private cost per roll is 20,000 ÷ 500 = RM 40. External cost per roll is 5,000 ÷ 500 = RM 10. Social cost per roll is RM 50.
Step 5, size of the external part. Compared with private cost, 5,000 ÷ 20,000 = 25%. Compared with social cost, 5,000 ÷ 25,000 = 20%. The two percentages differ because the base differs. The percentage-base explorer lets you test that.
A firm that sets its price using only RM 40 per roll is ignoring RM 10 of real cost. That is the seed of market failure, which the next lesson builds on.
The mistake to watch for
Mistaken answer: “The external cost is RM 25,000 because that is the total cost to society.”
The student has reported the social cost, not the external cost. Social cost includes the firm’s own RM 20,000.
Correction: external cost is only the part borne by outsiders, so subtract the private cost: 25,000 − 20,000 = RM 5,000. Always label the number you give: private, external or social.
A second slip is to call the firm’s own pollution control spending an external cost. If the firm pays for filters, it is a private cost.
Check yourself
1. Sort each item as private or external: (a) a bakery’s flour bill, (b) neighbours losing sleep because of the bakery’s early-morning machines, (c) the bakery’s rent.
Show answer
(a) private, (b) external, (c) private. Only (b) falls on third parties who are not paid.
2. A fictional printing firm, Sungai Cerah Printing, has private costs of RM 12,000 for a run and causes RM 3,000 of noise and waste harm to nearby shops. Find the social cost and the external cost as a percentage of social cost.
Show answer
Social cost = 12,000 + 3,000 = RM 15,000. External share = 3,000 ÷ 15,000 = 20%.
3. The printing firm agrees to pay the shops RM 3,000 for the harm. What happens to the classification?
Show answer
The RM 3,000 is now paid by the firm, so it becomes a private cost. Private cost rises to RM 15,000 and nothing is left external in this example.
Where this leads next
Next, see how the opposite case works in explaining under-consumption in a stated model. The ratios with interpretation limits tool helps when you compare costs per unit.
Many students find the split obvious in a table and slippery in a paragraph of unfamiliar context. A teacher in online one-to-one Economics tuition can use your own marked answers to find exactly where the sorting slips.