External benefit?

Question

When there are external benefits to an action, does the market produce too much or too little? What policies should the government follow in this case?

Answer 1

A positive externality exists when an individual or firm making a decision does not receive the full benefit of the decision. The benefit to the individual or firm is less than the benefit to society. Thus when a positive externality exists in an unregulated market, the marginal benefit curve (the demand curve) of the individual making the decision is less than the marginal benefit curve to society. With positive externalities, less is produced and consumed than the socially optimal level.

There are many common examples of a positive externality. Immunization prevents an individual from getting a disease, but has the positive effect of the individual not being able to spread the disease to others. Keeping your yard well maintained helps your house's value and also helps the value of your neighbors' homes. Beekeepers can collect honey from their hives, but the bees will also pollinate surrounding fields and thus aid farmers.

In order to get consumers to consume more of a good that has a positive externality, a subsidy can be given to them. The subsidy will increase the marginal benefit they receive when they consume the good. The subsidy should be payed for by all those who receive the external benefits.