Economics is concerned with the problem of choice. When you decide to do something, you give up the opportunity of doing something else because your resources are limited.

Each decision made regarding the allocation of resources has an cost – an opportunity cost – the cost of something in terms of the best alternative you choose to go without it.

Government is responsible for defence, education, roads, airports, parks and health services. It wide ranging responsibilities means that the government has to make decisions regarding the allocation of resources since capital (money to invest) is limited. The government must make investment decisions which ensure the greatest possible satisfaction to society.

The government must decide whether it is better for society to build a new hospital, build a new stretch of motorway or order a new aircraft carrier. In order to help this decision making process the government could use Cost Benefit Analysis (CBA). CBA could be used in order to assess the value (benefits) of these projects and also the negative consequences (costs) of these projects.

The technique can also be applied to business decisions. Businesses want to make a profit and will therefore try to minimise the costs of the business. Some costs are unavoidable. Firms must pay for the raw materials that they use and they must pay for the labour used in the production process. These are examples of private costs. Other costs can be avoided by firms and are borne by society. A firm which dumps untreated chemical waste into a local river is minimising its private costs but is increasing the social costs to society. In doing it will hope to increase its private benefits (profit).

Private costs and external costs are collectively known as social costs. Social costs represent the true costs of production. Government can force firms to internalise the costs of their activities by issuing licences or by making them true cost of production through landfill taxes or emission charges on pollutants. In this way negative externalities can be internalised
As economic growth occurs production and consumption of goods and services will increase market externalities may arise. Production and consumption of goods and services both create costs and benefits. The costs and benefits arising from production and consumption may be private or social. Market failure may arise where the externalities associated with production or consumption are high.

Private costs and benefits are those costs and benefits experienced only by the individual producer or consumer of a good or service. Public or social costs and benefits may be experienced as a result of production or consumption by producers, consumers and the wider community. If social costs exceed private costs, then a negative externality exists.

Externalities do not have to be negative. The construction of a new sports stadium on a contaminated industrial site may provide significant benefit to the local community over many years. If the social benefit gained from building the new stadium is greater than the private benefit, a positive externality is said to exist.

If efficient production is the primary objective then firms should seek to produce at the point where the extra cost arising from one extra unit of output is exactly equal to the extra benefit from any production or consumption decision.

The diagram above shows the marginal social benefit (MSB) that society as a whole will gain from each extra unit of consumption. The marginal social cost curve (MSC) illustrates the extra cost to society as a whole of each extra unit of consumption.

If the marginal social benefit exceeds the marginal social cost it is possible for further gains to be made by increasing consumption.

If the marginal social cost (MSC) exceeds the marginal social benefit (MSB) then the extra cost to society of consuming each extra unit is greater than the benefit gained. Production should be cut.

Efficiency is achieved at the point at which the marginal social benefit curve intersects the marginal social cost curve. In reality it may be difficult to determine where this point is.

Pollution is often used as an example of how MSB and MSC can be used to inform decision making. Car manufacture and car usage contributes to pollution. Society may benefit from production of cars being reduced and resources being switched to other uses. Manufacturers are interested in maximising profits. Pollution is not their primary concern. They will choose to produce at the point where supply and demand intersect. For society as a whole the desirable level of output may be less (the point where MSB and MSC intersect)

Negative externalities are not only associated with production. They may also occur from the consumption (people buying cars and driving them). Vehicle use may lead to congestion and atmospheric pollution. In this case the social benefit may be less than the negative externality of exhaust fumes. Ensuring that consumers reduce their consumption and that firms curb production may require government intervention.

One of the problems associated with cost benefit analysis is that it can be difficult to evaluate externalities. Some costs and benefits are fairly easy to assess and place a value on them. Other costs are harder to place a value on. A local resident who finds a nuclear plant planned for his doorstep will be concerned about the loss of amenity and may be worried about the health implications. Placing a value upon increased worry and loss of amenity is difficult. Economists will try to ‘impute’ (guess) a monetary value for these ‘costs’.