Lesson preview · Spillovers
Positive externalities: why markets make too little
~7 min · Free to read
Amira gets a flu jab at her local clinic. It costs her the clinic’s fee, a short wait and a sore arm for a day or two. In return, she is less likely to catch flu this winter.
But Amira isn’t the only winner. Flu spreads when people cough and sneeze. If she doesn’t catch it, she can’t pass it on to her little brother, her classmates or the bus driver. They gain from her jab, and none of them paid for it.
Key Term
Positive externality
A positive externality is a benefit that lands on third parties: people outside the deal, who neither bought nor sold the good. They pay nothing for it. So the buyer and the seller leave it out when they decide how much to buy or make.
Positive externalities come in two kinds, depending on where the spillover starts.
In consumption, it comes from using the good. Amira’s jab is one. Education is another: a student gains skills, and workmates can later learn from them. Here the buyer’s own benefit from one more unit is its marginal private benefit, shown by the demand curve. It is below the benefit to everyone (the marginal social benefit).
In production, it comes from making the good. A beekeeper’s bees pollinate the fruit trees on nearby farms. If the fruit growers don’t pay for this, it is a spillover. A firm’s research gives rival firms ideas they can copy for free. Here the producer’s own cost of one more unit is its marginal private cost, shown by the supply curve. It is above the cost to society (the marginal social cost). Society’s cost is lower because each unit also does other people some good.
Consumption case: the spillover adds to the benefit side.
Production case: the spillover takes away from the cost side.
Either way, unless the people involved strike a deal, the person deciding ignores the gain to others. So the market makes too little: fewer jabs, fewer hives and less research than would be best for everyone.
In both cases the market stops at 4 units, but 5 would be best. Each unit between 4 and 5 is worth more to society than it costs. Nobody buys or makes those units, because the person deciding gets none of the 2 dollars that others gain. That is under-production. It is a market failure (left alone, the market gets the quantity wrong), even though the spillover is a benefit, not a harm.
Trap · Common Misconception
"Positive" doesn't mean the market gets it right
Some students think only harmful spillovers cause problems. But an unpaid benefit also pushes the market away from the best quantity, just in the other direction. A negative externality means too much. A positive externality means too little.
Tip
Where does the social curve go?
Demand and supply don’t move: you add a social curve beside one of them. Ask where the spillover starts. From using the good (jabs, education)? Draw a social benefit curve above demand. From making the good (bees, research)? Draw a social cost curve below supply.
Trap · Warning
Not the same as a merit good
A merit good is something society judges people should have more of than they would choose, such as healthcare or education. Often people underrate how much it helps themselves. Some textbooks define merit goods by their positive externalities, and many merit goods do have them. But in this course the ideas are kept apart. A positive externality is a benefit to other people. A merit good is a judgement about what is good for the user.
Tip
Sometimes a deal fixes it
In 1973, the economist Steven Cheung published a study of beekeepers in Washington State, in the US. They didn’t wait for the government. Fruit growers paid them to bring hives to their orchards, so the pollination was no longer an unpaid spillover. The fee was higher for crops whose flowers give the bees little honey. A much bigger 2012 study of the same region found the same. Evidence: robust.
A deal like that works when only a few people share the spillover. It can’t work for flu jabs, because Amira can’t send a bill to everyone her jab protects.
Check yourself · no marks
Kofi stays at school for two more years. Name one benefit he gets himself and one that spills over to other people. Which kind of positive externality is the spillover?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Practice · 1 / 6
Lin gets a flu jab. Because she is less likely to catch flu, her flatmates are less likely to catch it from her. What are the flatmates getting?
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