A Positive Externality on Consumption

01
of 06

Benefits of Consumption versus Benefits to Society

Pos-Ext-Cons-1.png

A positive externality on consumption occurs when the consumption of a good or service confers a benefit on third parties who are not involved in the production or consumption of the product. For example, playing music creates a positive externality on consumption, since, at least if the music is good, the music confers a (non-monetary) benefit on other people nearby who otherwise have nothing to do with the market for the music.

When a positive externality on consumption is present, the private benefit to the consumer of a product is lower than the overall benefit to society of consuming that product, since the consumer doesn't incorporate the benefit of the externality that he creates. In a simple model where the benefit conferred on society by the externality is proportional to the quantity of output consumed, the marginal social benefit to society of consuming a good is equal to the marginal private benefit to the consumer plus the per-unit benefit of the externality itself. This is shown by the equation above.

02
of 06

Supply and Demand With a Positive Externality on Consumption

Pos-Ext-Cons-2.png

In a competitive market, the supply curve represents the marginal private cost of producing a good for the firm (labeled MPC) and the demand curve represents the marginal private benefit to the consumer of consuming the good (labeled MPB). When no externalities are present, no one other than consumers and producers is affected by the market. In these cases, the supply curve also represents the marginal social cost of producing a good (labeled MSC) and the demand curve also represents the marginal social benefit of consuming a good (labeled MSB). (This is why competitive markets maximize the value created for society and not just the value created for producers and consumers.)

When a positive externality on consumption is present in a market, the marginal social benefit and the marginal private benefit are no longer the same. Therefore, a marginal social benefit is not represented by the demand curve and is instead higher than the demand curve by the per-unit amount of the externality.

03
of 06

Market Outcome versus Socially Optimal Outcome

Pos-Ext-Cons-3.png

If a market with a positive externality on consumption is left unregulated, it will transact a quantity equal to that found at the intersection of the supply and demand curves, since that is the quantity that is in line with the private incentives of producers and consumers. The quantity of the good that is optimal for society, in contrast, is the quantity located at the intersection of the marginal social benefit and marginal social cost curves. (This quantity is the point where all units where the benefits to society outweigh the cost to society are transacted and none of the units where the cost to society outweighs the benefit to society are transacted.) Therefore, an unregulated market will produce and consume less of a good than is socially optimal when a positive externality on consumption is present.

04
of 06

Unregulated Markets with Externalities Result in Deadweight Loss

Pos-Ext-Cons-4.png

Because an unregulated market doesn't transact the socially optimal quantity of a good when a positive externality on consumption is present, there is deadweight loss associated with the free market outcome. (Note that deadweight loss is always associated with the suboptimal market outcome.) This deadweight loss arises because the market fails to produce units where the benefits to society outweigh the cost to society and therefore doesn't capture all of the value that the market could create for society.

Deadweight loss arises from units that are greater than the market quantity but less than the socially optimal quantity, and the amount that each of these units contributes to deadweight loss is the amount by which marginal social benefit exceeds marginal social cost at that quantity. This deadweight loss is shown in the diagram above.

(One simple trick to help find deadweight loss is to look for a triangle that points toward the socially optimal quantity.)

05
of 06

Corrective Subsidies for Positive Externalities

Pos-Ext-Cons-5.png

When a positive externality on consumption is present in a market, the government can actually increase the value that the market creates for society by providing a subsidy equal to the benefit of the externality. (Such subsidies are sometimes referred to as Pigouvian subsidies or corrective subsidies.) This subsidy moves the market to the socially optimal outcome because it makes the benefit that the market confers on society explicit to producers and consumers, giving producers and consumers the incentive to factor the benefit of the externality into their decisions.

A corrective subsidy on consumers has depicted above, but, as with other subsidies, it doesn't matter whether such a subsidy is placed on producers or consumers.

06
of 06

Other Models of Externalities

Externalities don't only exist in competitive markets, and not all externalities have a per-unit structure. That said, the logic applied in the analysis of a per-unit externality in a competitive market can be applied to a number of different situations, and the general conclusions remain unchanged in most cases.