Positive Externalities

You're sitting in class, and a concept comes up that confuses you. You want to ask a clarifying question, but don't want to interrupt the flow of class.

You look around, and to your dismay, no one else looks confused. Secretly... you were hoping someone else would ask your question so you can alleviate your confusion without needing to do anything!

Lucky for you, Johnny raises his hand and asks the same question that you had!

Johnny asking your clarifying question (without you needing to do anything) means that you have just experienced a positive externality!

What's an externality?

Let’s first start with understanding externalities in general. 

Externalities are the costs or benefits of a market activity that affect a third party other than the buyers and sellers in the market. The externality can be the result of either production or consumer activities.

With this considered, it's important to understand that externalities are a type of market failure. Why? Because they're an unintended consequence of market activity!

Externalities are a type of market failure, which occur when there's an inefficient allocation of resources in a market.

Why are we dealing with a positive externality here?

Johnny was confused on the same concept as you and raised his hand to get the same clarifying question answered.

Johnny did this to alleviate his own confusion.

However... yourself (and probably other students!) also got their same (but unspoken) clarifying question answered! This is a spillover benefit from Johnny asking his clarifying question!

Positive externalities are commonly referred to as spillover benefits. It's when the benefits "spillover" to someone other than the direct consumer or producer.

In this case, the benefits Johnny is receiving by getting his clarifying question answered (alleviation of his own confusion) are "spilling-over" onto other students who were confused about the same concept!

Graphical representation

You may hear about private marginal & marginal social costs / benefits associated with externalities. It's easiest to understand these when graphed visually.

We'll start by graphing the private marginal cost & benefit, and then the marginal social cost & benefit!

Private marginal cost & benefit (PMC & PMB)

Let's start by graphing the private marginal cost (PMC) & private marginal benefit (PMB):

You may notice that these look very similar to the typical supply & demand curves, with...

  • Marginal social cost (MSC) = Supply
  • Marginal social benefit (MSB) = Demand

Private marginal cost (PMC)

To be clear: the private marginal cost (PMC) in this situation is Johnny raising his hand and verbally asking his clarifying question.

NOTE: Typically, the cost will have an associated "$" value. Nonetheless, our situation with Johnny still represents positive externalities (in a very relatable way!). There is a cost (ex: awkwardness to interrupt class and ask a question) to Johnny's action!

The private marginal cost (PMC) is the direct cost to producers for producing an additional unit of a good.

Private marginal benefit (PMB)

The private marginal benefit (PMB) is the alleviation of confusion that Johnny (and only Johnny) receives for asking his clarifying question.

The private marginal benefit (PMB) is the direct benefit to consumers of consuming an additional unit of a good.

Now... what about the yourself (and the other students) who didn't need to ask the clarifying question, but benefited from Johnny asking it?

Marginal social cost & benefit (MSC & MSB)

Let's start with the marginal social benefit (MSB) here.

Marginal social benefit (MSB)

You (and the other silent students) are receiving a benefit (alleviation of confusion) without needing to do anything. That's a benefit that's not currently incorporated into the private marginal benefit (PMB) of Johnny alleviating his own confusion with his clarifying question!

In other words, you and the other silent students are receiving benefits without needing to do anything!

We can represent that increase in benefits with marginal social benefit (MSB) like so!

The marginal social benefit (MSB) is the private marginal benefit (PMB) plus any additional benefits imposed on the third party for consuming an additional unit of a good.

To be abundantly clear: the reason that marginal social benefit (MSB) is higher than private marginal benefit (PMB) is because the benefit of Johnny asking his clarifying question is more than just Johnny getting his confusion alleviated (PMB). Other students (currently not included in PMB) are getting their confusion alleviated too (MSB)!

Marginal social cost (MSC)

In terms of the marginal social cost (MSC), the full cost of Johnny asking his clarifying question is being realized by you and the other silent students. There's no other unintended costs being realized by third parties.

Therefore, the marginal social cost is equal to the private marginal cost!

The marginal social cost (MSC) is the private marginal cost (PMC) plus any additional costs imposed on the third party for producing an additional unit of a good.

Understanding equilibrium

Currently, our market for questions asked in class is operating at Q1...

...when, in reality, it should be operating at Q2 (if it were properly considering the benefit on third parties, a.k.a. the MSB).

Put in verbal, simpler terms: more questions should be asked in class! The market is currently "not considering" the benefits to third parties for clarifying questions being asked in class.

Governmental correction

In times like these, where the market is not adequately considering the benefits of producing a good (asking clarifying questions), the government may step in to make sure the market quantity aligns with the equilibrium quantity at marginal social benefit (MSB) at Q2.

Imagine that Miami University is our government entity in this situation, and they want to shift the demand curve to the right so that it properly considers the marginal social benefit (MSB).

They might institute a reward given to students for asking clarifying questions (ex: a free cookie), which would therefore increase the demand to ask clarifying questions (from PMB1 to PMB2)...

...resulting in the new equilibrium quantity (Q3) equaling the market quantity at the marginal social benefit (MSB) (Q2)!

Question #1: The socially optimal quantity will equal the market quantity once external benefits are considered in the situation of a positive externality. True or False?

Answer: True

Once the market takes into consideration any external benefits that affect third parties, the equilibrium quantity and socially optimal quantity become the same value!

Please see our Positive Externalities article for more context here.

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ApplyPRACTICE PROBLEM BANK (PREVIEW ONLY)
ConceptPositive Externalities
ConceptNegative Externalities (PREVIEW ONLY)
ConceptPublic vs. Private Goods (PREVIEW ONLY)
ConceptCost Curves (Mathematically) (PREVIEW ONLY)
ConceptCost Curves (Graphically) (PREVIEW ONLY)

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