Which statement correctly defines external cost and external benefit?

• A. External cost: an added cost to society borne by producers; external benefit: a benefit to producers.
• B. External cost: a private cost borne by the firm; external benefit: a private benefit received by the firm.
• C. External cost: an added cost to society not borne by the producer; external benefit: a benefit to society not captured by the private producer.
• D. External cost: a tax paid by consumers; external benefit: a subsidy paid by taxpayers.

Answer: (C)

When we talk about externalities, we distinguish private effects on the decision-maker from the broader effects on society. An external cost is an added social cost that the producer does not bear; the producer’s private cost is smaller than the total cost society pays. An external benefit is a benefit to society that the private producer does not capture; the producer receives some private benefit, but society gains more in total than the producer alone.

So the best statement is that external costs are added to society not borne by the producer, and external benefits are benefits to society not captured by the private producer. This captures the idea that market participants don’t bear all the costs or reap all the benefits of their actions, leading to potential market failure.

Why the other descriptions don’t fit: external cost isn’t a cost paid by producers themselves (that would be a private cost), and external benefit isn’t simply a private benefit to the producer (there are extra societal gains not captured by the producer). Also, external costs and benefits aren’t defined by taxes or subsidies paid by others; those are policy tools, not the basic definitions of externalities.