Question: Define the term external benefit. What are some examples? Assess at least 2 strategies to internalise an external benefit.
An external benefit is an unpaid for benefit enjoyed by third parties not directly involved in a market transaction. A positive externality occurs when MSB > MPB as there is an external benefit to third parties.
At market equilibrium, agents act in their own self-interest and set MPB = MPC at P* and Q*. The socially optimum equilibrium is MSB = MSC at P’ and Q’. A positive externality occurs here because MSB > MPB. Benefits are enjoyed by third parties but the benefits are not fully exploited. The sum of these potential benefits is the welfare loss to society. Market failure occurs because the good is under-consumed.
Some examples of positive externalities include:
- A neighbour making their garden beautiful makes the neighbourhood look better and may cause local property prices to rise.
- Knowledge or invention spill-overs like the internet, everyone has benefited for free from the U.S. Army’s invention.
- A better health system means the population lives longer with a better quality of life.
The government must intervene to correct market failure. The government could use subsidies or regulation.
A subsidy is a grant given by the government to producers to encourage the production of a good. A subsidy can be given to producers equal to the external benefit at the socially optimum level. The subsidy decreases a firm’s private costs and makes MPC shift right. Market price falls from P* to P’ and output rises from Q* to Q’. At MPB = MPC + s, the market is now at its socially optimum level.
But, what is the opportunity cost of the subsidy? A decrease in government spending on health, education and/or the infrastructure? Maybe a subsidy for a positive externality should be funded by a Pigouvian tax on a negative externality.
Alternatively, the government could provide the good/service for free. In the U.S., kindergarten, elementary and high school are all free but a college education must be paid for.
However, this could result in government failure because providing something for free could cause consumers to use it too much at an inefficiently high level.