Separate the buyer's own gain from the spillover.
A positive externality is an unpriced benefit to third parties from production or consumption. Marginal social benefit equals marginal private benefit plus marginal external benefit. With no external cost, MSC = MPC. If decision makers consider only private benefits, they may stop before the social optimum: additional units could benefit society more than they cost.
- Third party
- A positive externality is an unpriced benefit to someone outside the decision. A trainee's own gain is private; an additional safety gain for co-workers can be external.
- Private and external benefit
- Marginal external benefit (MEB) is the benefit to others from one more unit. Add it to marginal private benefit (MPB) to obtain marginal social benefit: MSB = MPB + MEB.
- Quantity
- With no external cost, MSC = MPC. Decision makers who count only their own benefit may stop too soon: more units could benefit society by more than they cost.
Avoid calling every benefit external
Paid-for versus spillover
A worker paid for extra output may capture a private return. To establish a spillover, identify a benefit to someone else that is not fully priced or rewarded.
Diagram
Label MSB above MPB by MEB, and MPC=MSC. Qsocial is greater than Qmarket. Shade forgone net benefit over the missing units.
Zero is not the policy target
Some resources are costly even for beneficial services. Maximising output without considering MSC can go beyond the optimum.
Worked example: Training that benefits nearby teams
A safety course helps its participants and also reduces accident risks for co-workers who do not pay for those spillover benefits. MPB = 20 - 0.1 Q, MPC = 4 + 0.1 Q and MEB = $4 per course place. Q is course places per day; marginal values are dollars per place.
- The participant's own safer work is a private benefit. The separate reduction in co-workers' risk is the external benefit in this example.
- MSB = 24 - 0.1 Q, lying $4 above MPB. Assume no external cost, so MSC = MPC.
- The private equation remains 20 - 0.1Q = 4 + 0.1Q, giving Q = 80. Including the spillover gives 24 - 0.1Q = 4 + 0.1Q, so 20 = 0.2Q and the social quantity is 100.
- Between 80 and 100, the extra social benefit exceeds the extra resource cost. Those beneficial places are missing from the private outcome.
Watch out for this
A person earning more after training is automatically a positive externality.
A gain received by the person making the decision is a private benefit. Identify an additional unpriced benefit to others.
Check your understanding
A course raises a participant's own earnings and separately improves safety for other workers. Which part establishes the external benefit?
- The unpriced safety gain for other workers.
- All of the participant's own earnings gain.
- The fee paid to the course provider.