Definition of Positive Externality: This occurs when the consumption or production of a good causes a benefit to a third party. For example:
- When you consume education you get a private benefit. But there are also benefits to the rest of society. E.g you are able to educate other people and therefore they benefit as a result of your education. (positive consumption externality)
- A farmer who grows apple trees provides a benefit to a beekeeper. The beekeeper gets a good source of nectar to help make more honey. (positive production externality)
- If you walk to work, it will reduce congestion and pollution; this will benefit everyone else in the city.
With positive externalities, the benefit to society is greater than your personal benefit.
Therefore with a positive externality the Social Benefit > Private Benefit
- Remember Social Benefit = private benefit + external benefit.
Diagram of Positive Externality (consumption)
- In this case, the social marginal benefit of consumption is greater than the private marginal benefit. For example, if you take a train, it reduces congestion for other travellers.
- In a free market, consumption will be at Q1 because demand = supply (private benefit = private cost )
- However, this is socially inefficient because at Q1, social marginal cost < social marginal benefit. Therefore there is under-consumption of the positive externality.
- Social efficiency would occur at Q2 where social cost = social benefit
For example, in a free market without government intervention, there would be under-consumption of education and public transport.
Positive externality (production)
- This occurs when a third party benefits from the production of a good. For example, building a train station may provide shelter for the homeless when it is raining.
- If a company develops new technology, such as a database programme, this new technology can be implemented by other firms who will gain a similar boost to productivity.
- Tim Berners Lee who developed the World Wide Web, made it freely available, creating a very large positive externality.
Diagram of positive externality in production
- Because there are positive externalities in production, the social marginal cost of production is less than the private marginal cost of production.
- In a free market, a firm will ignore benefits to third parties and will produce at Q1 (free market outcome)
- However, the socially efficient level will be at Q2 (where social marginal cost = social marginal benefit)
Dealing with positive externalities
Positive externalities lead to under-consumption and market failure. Government policies to increase demand for goods with positive externalities include
- Rules and regulations – minimum school leaving age
- Increasing supply – government building of council housing to increase stock of good quality housing.
- Subsidy to reduce price and encourage consumption, e.g. government subsidy for rural train services.
Diagram to show effect of subsidy on good with positive externalities
A subsidy of P0-P2 shifts supply curve to the right (S2) and the new quantity demand will be Q2 (where SMB=SMC)
In this case, the subsidy has overcome the market failure. Though government intervention itself could be subject to government failure.
- more detail at: Subsidy on positive externality
Which diagram to draw?
Either (production or consumption externality) is acceptable to show the principle of positive externalities. Generally, I advise using the positive externalities of consumption. To simply economics for some students (who often get confused by these diagrams), I will only teach one positive externality diagram. (consumption)
- Positive externalities in the housing market – examples of positive externalities in the housing market, such as improved local communities, improved public health and better environmental standards.
- Subsidy on positive externality
- Negative externality
- Should we pay to see the doctor?
Last updated: 10th July 2017, Tejvan Pettinger, www.economicshelp.org, Oxford, UK