Market Failure: Positive Externalities (AQA A Level Economics)

Positive Externalities of Production

• Positive externalities of production are often created during the production of a good/service

  • The externalities are caused by producer supply and result in a positive external impact on a third-party

• The market is failing due to under-provision of these goods and services, as only the private benefits are considered by the producers and not the external benefits, causing market failure

  • If the external benefits were considered, the quantity of goods and services produced would increase, and they would be sold at a lower price

  • E.g. The production of honey increases the number of bees in an area, which increases pollination potentially helping other food producers in the area

Diagram: Positive Externality of Production

External benefits of production (positive externality) resulting in an under-production equal to Q_opt - Q_e

Diagram analysis

• The marginal social benefit (MSB) is assumed to equal the marginal private benefit (MPB) as the focus is on the producer (supply) side of the market

• The free-market equilibrium can be seen at P_eQ_e. This is where the MPC = MSB

• The larger the external benefits in production, the larger the gap between the marginal social cost (MSC) and the marginal private cost (MPC)

• The optimum allocation of resources from society’s point of view would generate an equilibrium where MSB = MSC. This can be found at P_optQ_opt. There is no market failure at this equilibrium

• The free market is failing due to under-provision of this good/service equal to Q_{opt -} Q_e

• At any quantity produced below Q_opt, the MSB is greater than the MSC, resulting in lost benefits and a deadweight loss to society (pink triangle)

• To be socially efficient, more factors of production should be allocated to producing this good/service

• There is an opportunity for government intervention (indirect taxes, legislation, regulation, etc.), to force this market to be more socially efficient

• Any intervention that reduces the welfare loss will be beneficial

Positive Externalities of Consumption

• Positive externalities of consumption are created during the consumption of a good/service

  • The externalities are caused by consumer demand and result in a positive external impact on a third-party

• As only the private costs are considered by consumers and not the external costs, individuals will under-consume these goods/services causing a market failure

  • If the external benefits were considered, the demand would increase, and the goods would be sold at a higher price

  • An example of a positive externality of consumption is vaccinations. These protect those that receive them, but also prevent the spread of disease to others around them. Other examples include education, healthcare and healthy eating

Diagram: Positive Externality of Consumption

External benefits of consumption (positive externality) result in an under-consumption equal to Q_opt - Q_e

Diagram analysis

• The MSC is assumed to be equal to the MPC as the focus is on the consumer (demand side) of the market

• The larger the external benefits in consumption, the larger the gap between the MPB and MSB

• The optimal allocation of resources for society would generate an equilibrium where MSB = MSC

  • This can be found at P_optQ_opt which is allocatively efficient

  • There is no market failure at this equilibrium

• The free-market equilibrium allocates resources at the private optimum as consumers fail to take into account the positive externalities from consumption, resulting in a welfare loss

  • This is shown at P_eQ_e where the MPB=MSC

• As the MPB are less than the MSB, this results in an under-consumption equal to Q_opt - Q_e

• At any quantity consumed below Q_opt, the MSB is greater than the MSC, resulting in lost benefits and a deadweight loss to society (pink triangle)

• To be socially efficient, more factors of production should be allocated to producing this good/service

• There is an opportunity for government intervention (subsidies, partial provision, etc.) to force this market to be more socially efficient and reduce the overall welfare loss to society