Positive Externality of ProductionSL
MicroeconomicsA diagram illustrating a positive externality of production, where the marginal social cost (MSC) is lower than the marginal private cost (MPC), leading to underproduction and welfare loss.
Curves and elements
- demand
- Demand Curve (MPB = MSB): Represents marginal private and social benefit, assuming no externalities in consumption.
- mpc
- MPC (S): Marginal private cost — the cost borne by producers.
- msc
- MSC: Marginal social cost — the lower true cost to society, including external benefits.
- price effect
- Price Effect: The socially optimal price (Popt) is lower than the market price (Pm).
- quantity effect
- Quantity Effect: The free market underproduces (Qm) compared to the socially optimal quantity (Qopt).
- welfare loss
- Welfare Loss: The triangle representing the deadweight loss due to underproduction caused by unaccounted external benefits.
Key explanations
- 1
Positive externalities of production occur when a firm's output generates external benefits to third parties that are not reflected in market prices.
- 2
In the free market equilibrium, firms produce at Qm where marginal private cost (MPC) equals marginal private benefit (MPB), resulting in price Pm.
- 3
However, the socially optimal output is Qopt, where marginal social cost (MSC) equals marginal social benefit (MSB).
- 4
Because MSC < MPC, the market underproduces (Qm < Qopt), and too few resources are allocated to the good.
- 5
The shaded triangle represents welfare loss — the benefit to society that is lost due to the lower level of production.
Example exam question
Using a diagram, explain how a positive externality of production can lead to market failure. Suggest a policy a government could use to correct the underproduction.
Show example answer
In the diagram, the market equilibrium is at Qm and Pm, where firms only consider private costs (MPC). However, production also creates external benefits (e.g. research spillovers or job training), which means the true cost to society is lower (MSC). The optimal level of output is Qopt at price Popt, where MSC = MSB. Underproduction causes welfare loss, as shown by the shaded triangle. The government could encourage increased output through subsidies, tax breaks, or direct provision, moving the market closer to the socially optimal level.
