Chapter 6 · Market failure and socially undesirable outcomes II: Positive externalities, public goods, asymmetric information and inability to achieve equity
Positive production externality
Compare private and social costs when production benefits third parties. Explain underproduction and identify the socially efficient output.
The economic idea
A positive production externality exists when producing a good or service creates an uncompensated benefit for third parties. The firm receives the private return from its output, while additional benefits spill over to other producers, workers or communities.
Marginal private cost is the additional cost borne by the producer. Marginal external benefit of production is the additional benefit received by third parties. In the standard IB cost representation, marginal social cost is below marginal private cost by the value of that external benefit.
Because the externality originates in production, the model assumes no separate consumption externality and therefore shows marginal social benefit equal to marginal private benefit. The market reaches MPB = MPC, but allocative efficiency requires MSB = MSC.
Producers do not receive the full social return from the activity, so their private cost appears too high relative to the cost to society. The market price therefore fails to reward all of the benefit created and output remains below the socially efficient quantity.
Deadweight loss is the net social benefit forgone on units between the market quantity and the social optimum. It is not the total external benefit created by every unit of production.
Reading underproduction caused by an external production benefit
“Price” is measured vertically and “Quantity” horizontally. The vertical scale records marginal benefit or cost per unit.
“MSB = MPB” represents both marginal private benefit and marginal social benefit because the model isolates a production externality.
“MPC” is the additional cost paid by the producer. “MSC” is lower because society receives a marginal external benefit from production.
The vertical distance between “MPC” and “MSC” represents marginal external benefit of production; it is not a subsidy unless government actually introduces one.
Private-market outcome: Eₘ
“Eₘ” is where “MSB = MPB” meets “MPC”, giving the market price “Pₘ” and quantity “Qₘ”. Producers respond only to the returns and costs they can capture privately.
Socially efficient outcome: E*
“E*” is where “MSB = MPB” meets “MSC”, giving “P*” and “Q*”. This comparison includes the benefit received by third parties.
Comparing Qₘ with Q*
“Qₘ” lies to the left of “Q*”. The free market therefore underproduces: between these quantities, “MSB = MPB” exceeds “MSC”, so marginal social benefit is greater than marginal social cost.
Read the benefit that the market leaves unrealised
Between “Qₘ” and “Q*”, “MSB = MPB” is above “MSC”. These missing units would create more benefit than cost for society. The area between those curves over that interval is the welfare loss from underproduction.
The external benefit is represented by the gap between “MPC” and “MSC”. It does not mean the firm receives a subsidy or that its own production costs have fallen. For example, a firm may pay to train a worker while another employer later benefits from the skills.
Why the market stops before the social optimum
Firms base production decisions on “MPC” because they cannot capture all benefits received by third parties.
The private market therefore settles at “Eₘ” and “Qₘ”, where private benefit equals private cost.
Counting marginal external benefit lowers the relevant social cost schedule from “MPC” to “MSC”.
Applying MSB = MSC gives “E*” and “Q*”. “Qₘ” lies to the left of “Q*”. The free market therefore underproduces: between these quantities, “MSB = MPB” exceeds “MSC”, so marginal social benefit is greater than marginal social cost.
What the current state establishes
The welfare-loss area between “Qₘ” and “Q*” measures the net social benefit forgone because those beneficial units are not produced.
Common mistakes to avoid
- “MSC” is not the firm’s market supply curve. Firms follow “MPC” unless policy or institutions allow them to capture the external benefit.
- A positive externality does not mean the market produces nothing. It means the market quantity is below the allocatively efficient quantity.
- The entire gap between MPC and MSC is not deadweight loss; welfare loss concerns the unproduced units between the two quantities.
- The production externality changes the relationship between private and social cost. It does not shift market demand in this model.
How to draw this diagram
- Title the diagram “Positive production externality”. Label the horizontal axis “Quantity” and the vertical axis “Price”.
- Draw MSB = MPB first and label it clearly.
- Draw MPC next and label it clearly.
- Draw MSC next and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The parallel cost curves imply a constant marginal external benefit. Actual knowledge and training spillovers may change as output expands.
- Benefits may emerge after a long time and spread across regions, making their value difficult to estimate.
- Firms may use contracts, patents or worker-retention policies to internalise part of the spillover, narrowing the market failure.
- Market power, uncertainty and imperfect capital markets can create additional reasons for low output.
- The diagram diagnoses underproduction but does not show the administrative, fiscal or opportunity costs of intervention.