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The existence of external benefit and external cost leads to misallocation of resources. External cost For example, when drivers are not liable for the health damage of car exhaust, drivers will equate only marginal private cost with marginal benefit. But if drivers are forced to pay for the health damage of car exhaust, their marginal cost will go up by the amount of the external cost.
1 An external costs occurs when producing or consuming a good or service imposes a cost upon a third party. 2  If there are external costs in consuming a good (negative externalities), the social cost will be greater than the private cost.