Positive Externalities
Explain the difference between positive externality of
consumption and production
Graph the different forms of positive externalities
Identify and explain how merit goods are underproduced
Why is there underallocation of resources when
there is a positive externality?
Types of market failure
• Externalities
– MSC>MPC, negative
externalities
– MSB>MPB, positive
externalities
• Under- and over-provision of
goods
– Merit goods/public goods
(underprovided—see positive
externalities)
– Demerit goods
(overprovided—see negative
externalities)
• Imperfect competition
– Oligopoly/monopoly means
that the market has failed to
provide more at a lower price
without firms making a loss
(decreases consumer surplus)
• Common access resources
– i.e., ocean, forests
– Lack of clear ownership rights
means there’s too weak an
incentive for anyone to take
care of resources, resulting in
over-use/sub-optimal
allocation
Positive externalities of production
• For third parties to benefit
from the production of a
good, the positive spillover effects must exist
whether the good is
consumed or not!
• Usually, this means that
more often than not,
these are indirect positive
externalities
• Positive externalities of
production are external
benefits created by
producers (MPC > MSC)
and MSB=MPB
So, what’s the problem?
• Positive externalities
create merit goods—a
good deemed so
beneficial that society
deems the good to be
underprovided by free
market forces
Examples of merit goods:
• Education
• Health care
• Pensions
• Wind/solar power energy
• Public housing
• As a result, the good is
also underconsumed
since consumers lack
sufficient information to
consume the “correct”
amount
– Welfare loss (positive
production)
Welfare loss
Welfare loss (positive
production)
• Underallocation of
resources to production
with a positive production
externality leads to
welfare loss (not enough
produced)
• Loss= difference between
MSB and MSC curves
relative to optimal output
(point of wl triangle is at
Qopt quantity of output)
Encouraging positive externalities
Increasing supply
• Government grants and subsidies to producers that generate
external benefits will reduce costs of production, and encourage
more supply. This is a common remedy to encourage the supply of
merit goods/public goods
• Such merit goods can be funded out of taxation
Increasing demand
• Demand for goods that create positive externalities, can be
encouraged by reducing the price paid by consumers, such as
subsidizing the tuition fees, or make the good completely free at the
point of consumption, such as free hospital treatment for contagious
diseases.
• Government can provide free information to consumers, which could
help develop a better understanding of the product and demand
more of it. For example, AIDS awareness programs can reduce
ignorance and encourage the use of protection.
• An additional option is to compel individuals to consume the good or
service that generates the external benefit. In terms of education,
attendance at school up until the age of 16 is compulsory, and
parents may be fined.
Correcting positive production
externalities
• Subsidies
– The gov’t provides
subsidy to a firm per
unit of good
produced, equal to
the external benefit
– Paid for by taxes
– Shifts MPC curve
towards MSC to
increase quantity to
Qopt, while price falls
to Popt
– Gov’t provision and
subsidies have the
same market
outcomes
Correcting positive production
externalities
• Direct government
provision
– The gov’t provides the
g/s creating the
positive production
externality (R&D)
– Paid for by taxes
– Shifts supply curve
right toward MSC, so
that Qopt (optimal Q)
will be produced, with
price falling from Pm
to Popt
Positive externalities of
consumption
• For third parties to benefit
from the consumption of
a good, the positive spillover effects must exist
whether the good is
consumed or not!
• Usually, this means that
more often than not,
these are indirect positive
externalities
• Positive externalities of
consumption are
external benefits created
by consumers (MSB >
MPB) and MPC=MSC
Positive externalities of consumption