External Benefit. An external benefit is an unpaid for benefit enjoyed by 3rd parties not directly involved in a market transaction. Marginal social benefit is greater than marginal social cost.
At market equilibrium, agents act in their own self-interest and set at P* and Q*. The socially optimum equilibrium is 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.
Positive externality examples:
- 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.