|Posted on April 18, 2014 at 9:20 AM|
An externality occurs when a third party (someone other than the buyer or seller) is affected by a market transaction. This is known as a market failure. Externalities can be positive or negative.
A positive externality occurs when the marginal social benefit (MSB) is greater than the marginal social cost (MSC). Society is benefitting from the production of the good. However, there is a misallocation of economic resources and deadweight loss. Markets underproduce goods that generate positive externalities.
The No Bull Review graph below illustrates a good that creates positive externalities (MSB>MSC). The area of deadweight loss (inefficiency) is the purple triangle. P1 and Q1 is socially optimal, however the market generates a price of P and quantity of Q. Society is getting too little of the good at too low of a price.
AP Microeconomics Unit 4 Role of Government