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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.
When external costs like these exist, they must be added to private costs to determine social costs and to ensure that a socially efficient rate of output is generated. Social costs include both the private costs and any other external costs to society arising from the production or consumption of a good or service.