In this video I’ll cover the concept of positive externalities.
By the end of this video you will be able to explain what a positive externality is
and and also be able to diagram a positive externality in consumption and also in production.
So what exactly is a positive externality?
A positive externality occurs when a third-party, NOT involved in an economic transaction, benefits
from THAT transaction.
A common example for consumption, is education, which I will explain further in the next few
slides.
Let’s first consider the case of positive consumption externalities.
With positive consumption externalities, the social benefit equals the private benefit
plus the external benefit.
Let’s break down what this means.
The social benefit represents the benefit to society as a whole.
The private benefit is the benefit received by the individual consuming the good or service
and the external benefit, or the externality, is the benefit to a third-party not involved
in the transaction.
In the case of education, there is a positive externality to educating an individual or
a population.
Educated persons can be more productive members of society and can contribute more to society
than they could with less education.
They are more informed citizens and potentially more actively involved in social issues, thus
promoting the development of society as a whole.
This is one of the key reasons why most governments around the world mandate public schooling
to a minimum age.
When laying out the diagram of an externality, we do so with costs and benefits on the Y
axis and output on the X axis.
Our marginal private cost and marginal social cost are the same here because we assume there
are no external costs.
This will become clearer as we explain the marginal benefit curves.
The marginal private benefit curve represents the benefit gained by the additional consumption
of a good or service.
The equilibrium price and output for this combination is P* and Q*.
The free market would provide Q* quantity at a price of P*.
If we factor in the marginal external benefit and add that to the marginal private benefit,
we arrive at our marginal social benefit.
This includes the benefit to the individual and all third parties.
You’ll notice it is to the right of the original marginal private benefit curve.
The socially optimum level of output is Qs at a price of Ps.
If this market was left to operate without any intervention, the result would be that
this good would be under provided when we consider the additional benefits tied to the
externality.
Therefore, we say that there is a welfare loss, or deadweight loss represented by triangle
XYZ, which I will now display.
To determine the welfare loss we consider the points at which the marginal social benefit
is greater than the marginal social cost, from our original equilibrium of P*Q*.
Since the marginal social benefit, Y, is greater than the marginal social cost, X, more of
this good should be produced.
The welfare loss represents the sum of the remaining benefit of those additional units
that are not being produced, represented by triangle XYZ.
The socially optimum level of production is where there marginal social cost is equal
to the marginal social benefit.
This happens at Ps Qs.
Having an understanding of positive consumption externalities should helps us understand what’s
next, positive production externalities.
In the case of a positive production externality, the social cost of production is equal to
the marginal private cost minus the marginal external benefits.
The supply curve shifts by the amount of the external benefit.
Consider the case of a private group of investors that decides to build a new basketball stadium.
The group incurs all the costs of construction but other firms, such as restaurants and hotels
around the local area, will benefit.
The other firms do not contribute to the construction of the stadium but they receive many of the
benefits.
The increased traffic and footfall to the area will generate more business for the hotels
and restaurants, and yet they’ve not contributed to the construction of the stadium that drives
this gain.
A positive production externality occurs when a third party gains as from the production
process of another firm.
However, those third parties who benefit cannot be charged, so there is only an incentive
to supply to those who can be charged.
Let’s work through the diagram.
We use the same axes as before.
This time we assume that our marginal private benefit and marginal social benefit curves
are the same.
Next we build in our marginal private cost.
If left to market forces, the production level would be Q* at a price of P*.
However, the marginal social cost is lower than the marginal private cost due to the
extensive benefits gained by firms not involved in the production process.
Thus the socially optimum level of output, Qs, is greater than the free market allocation,
Q*.
The socially optimum price, Ps, is also lower than the free market price, P*.
The welfare loss in this scenario is represented by the triangle XYZ.
We can see this by starting at our initial equilibrium point and noting that the marginal
social cost, Y, is lower than the marginal social benefit, X, and therefore production
should continue.
If we continue until marginal social benefit equals marginal social cost, we’ll note
that the free market allocation leaves us with a deadweight or welfare loss of triangle
XYZ.
I hope that makes sense for you, if not go back and watch it again.
If you’re still confused, leave a message below.
That wraps up this video on positive externalities.
By now you should be able to explain what a positive externality is and diagram both
consumption and production positive externalities.
If you have any questions or comments, leave them below or email me.
Visit the website listed below in the video information and check out the additional resources
available to help you study.
For now that’s us done and I will see you in the next one!