Externalities Costs of trade Private cost - Paid by the consumer or the producer. External cost - A cost paid by bystanders, by people other than the consumer or the producer. Social cost of trade = Private cost + External cost. Externalities deal with external cost. Market does not maximize social surplus. External Costs When there are external costs of trade, output should be reduced. Who bears the cost is irrelevant. Solutions Pigouvian Tax For example tax on cigarattes. Tax incre...