Positive Externalities

Idea

A positive externality arises when the production or consumption of a good confers an external benefit on third parties. Because the benefit is unpriced, the marginal social benefit lies above the marginal private benefit, and the free market under-allocates resources to the good — producing or consuming below the social optimum and generating a deadweight welfare loss.

Mechanism

The free market settles at $Q_m$, where $MPB = MPC$. The social optimum is $Q_s$, where $MSB = MSC$. Since $MSB$ exceeds $MPB$ by the marginal external benefit, $Q_m$ lies to the left of $Q_s$: the good is under-consumed (consumption externality) or under-produced (production externality) by $Q_s - Q_m$.

Over that shortfall, each unit would benefit society more than it would cost society, yet it is not traded. Summed across $Q_s - Q_m$, the forgone net benefit is the deadweight welfare loss — the triangle bounded by the free-market point, the social-optimum point, and the divergence between the social and private curves at $Q_m$.

• Positive consumption externality — the external benefit attaches to consumption (each person vaccinated lowers others’ chance of infection). The $MSB$ curve sits above $MPB$.

• Positive production externality — the external benefit attaches to production (a honey farm’s bees pollinate neighbouring crops, raising others’ yields). The diagram is structurally identical: $MSB$ above $MPB$, under-production $Q_s - Q_m$.

Diagram

Considerations

Because the externality is unpriced, the market over-prices the good relative to its true social benefit, which is why too little is traded — goods with positive consumption externalities are merit goods. The same diagram serves both the consumption and the production case — only the label on the divergent curve and the wording (under-consumption vs under-production) change. The corrective policies, and the limits on each, are set out in correcting positive externalities.