Positive externalities

Externalities can arise from both consumption and production, and may be positive or negative.

External benefits from production

An external benefit from production is the benefit that individuals (and other businesses) might gain as a result of the production of goods and services.

For example, when a business locates in a specific area it will provide jobs and income which then circulates around the local economy benefitting many third-parties.

External benefits from consumption

An external benefit from consumption is the benefit that ‘third-parties’ derive when others consume goods and services, but where they do not pay for this benefit.

For example, if your neighbour buys a car, and a few days later give you a lift to the train station – you have benefitted from their consumption, without paying! You are, in effect, a 'free rider'.

However, quantifying the value of positive consumption externalities is not not easy given that no money changes hands and hence there is no record of any benefits gained. Also, benefits are often derived over a very long period of time which makes them difficult to track and quantify.

Graphically, the commonest way to illustrate the effect of external benefits from consumption is to show the marginal social benefit curve to shifting upwards - where, at any given output, the social benefit is greater than the private benefit as a result of the existence of an external benefit. 

Positive externalities

Merit goods

The consumption of many types of goods and services generates benefits to others. The external benefit derived by third-parties is a key feature of 'merit' goods, which include education and healthcare.

For example, if an individual becomes inoculated against a infectious disease, other individuals may benefit as there is now one less person who might infect them. Similarly, when an individual receives education, many others benefit in a variety of way - such as those who directly receive the knowledge and skills they have acquired, along with benefits to the wider community from the higher taxes paid as a result of gaining a well paid job.

Hence, free markets are unlikely to allocate sufficient resources to merit goods, and other goods that generate positive externalities. Hence, the welfare loss the area a,b,c.

In practice it is not always easy to differentiate external benefits arising from consumption and production. Goods produced will eventually be consumed so that benefits can arise along the supply-chain and during consumption.

The merit good diagram

In the diagram below we can see that the socially efficient quantity of a merit good (QS) is greater than the market equilibrium quantity (Q). The shaded area, market 'a', 'b', 'c' is the net welfare loss associated with merit goods.

Positive externalities

Video on positive externalities

Why are externalities a market failure?

Demerit goods

What are the remedies for demerit goods?

Demerit goods

How does equilibrium create welfare?


facebook link logo twitter link logo email link logo whatsapp link logo gmail link logo google classroom link logo