market failure - positive externalities
Introduction
Positive externalities are often given less attention than negative externalities but there are often important and many exam questions ask you to explain how they exist, give relevant examples and show how positive externalities can cause market failure.
When positive externalities exist, the social marginal benefit from consumption of a good or service exceeds the private marginal benefit.
Merit goods are products that tend to be under-consumed by the free market because of information failure. Those people consuming education and health care, may not fully appreciate or value accurately how much private benefit they are deriving from the consumption of these services.
An individual will find it difficult to predict the monetary benefits of a good education and, as a result, because of the lack of information they may choose to curtail their schooling. Merit goods may also have important external benefits.
Examples that can be used include:
• Industrial training by firms: This can reduce the costs faced by other firms and has important effects on labour productivity
• Education: A well-educated labour force can increase efficiency and produce other important external benefits, such as lower unemployment and greater international competitiveness. Policy makers are realising the increased returns from investing in human capital and the beneficial impact it can have on the supply-side of the economy
• Health provision: Improved health provision and health care reduces absenteeism and creates a better quality of life and higher living standards
• Arts and sporting participation: visiting museums and theatres can increase knowledge. The external benefits of increased knowledge are hard to quantify, but probably important. Sporting participation will lead to a healthier nation and improve team-working skills
• Developers of a new housing estate spend money cleaning up contaminated land which encourages the regeneration of the surrounding area
Where substantial positive externalities exist, the good or service may be under-consumed by people or under-provided since the free market may fail to take into account their effects. This is because the marginal social benefits of consuming the good > private marginal benefits. An example of positive externalities arising from the consumption of education is shown in the diagram below. In the example a consumer benefits from education that increases productivity causing SMB to rise.
A market failure problem is likely to exist and persist because the benefit to society in terms of higher productivity and a higher GDP is un-priced by the market. This leads to the private optimum level of output being less than the social optimum level of production. The consumer does not take into account the external benefits of higher education (they may not be aware of the social benefits or may underestimate their own private benefits – this is an example of information failure)
The private optimum occurs where the private marginal benefit (the benefit to the individual of consuming the last unit) equals private marginal cost, giving an output of Qp. At this level of output, the distance ab represents the size of the external benefit. For society as a whole though the social optimum is where social marginal benefit (SMB) = social marginal cost at output Qs.
In terms of social efficiency education is under-consumed. The socially optimal level of output is where SMB=SMC. If we sum up the excess of SMB over PMB between Qs and Qp we arrive at a figure that indicates the deadweight welfare loss to society. This is the triangle abc. Society as a whole could be made better off by increasing the current level of output from Qp to Qs.
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