Definition – An external benefit occurs when producing or consuming a good causes a benefit to a third party.
The existence of external benefits (positive externalities) means that social benefit will be greater than private benefit.
Example of external benefit
In this example, of cycling to work, there is
- Private benefit
- We save on a bus fare.
- External benefit
- Other people benefit from less traffic congestion.
- Also, other people benefit from the production of less car pollution.
Social benefit = private benefit + external benefit
External benefit from consumption
In this case, there is an external marginal benefit of £4 from each unit.
In this diagram, the private marginal benefit is PMB. However, consuming the good gives a benefit to other people in society. The external marginal benefit is given by the difference between private marginal benefit and social marginal benefit
In a free market, goods with external benefits can often be under-consumed because the free market ignores the external benefit to others.
Example of external benefits from consumption
- Cycling to work helps to reduce the level of pollution and congestion. Therefore other road users have quicker journey times and help to reduce the level of pollution.
- Reduced risk of transferring disease. If you get vaccinated, the personal benefit is your own reduction in risk of disease. However, if you are inoculated there is also an external benefit – other people in society are less likely to be infected because you are healthy.
Example of external benefits from production
- Fruit tree pollination. A beekeeper produces honey, but as an external benefit, his bees help to fertilise nearby fruit trees.
- Reduced global warming. A firm who produces solar panels aims to make a profit. However, increased supply of solar panels has the external benefit of reducing greenhouse gases and reducing the impact of global warming.