Not every market failure involves harm. Some goods do so much good for people who never paid for them that the market makes far too little of them. A vaccinated child protects the whole classroom. A restored building lifts the value of the street. Nobody sends you a bill for that, and nobody sends you a cheque either, which is exactly the problem.
📘 What you need to know
A positive externality is a benefit that lands on a third party who did not pay for it.
A positive externality of production puts MSC below MPC. The good is under-provided.
A positive externality of consumption puts MSB above MPB. The good is under-consumed.
In both cases Qe is smaller than Qopt, so the triangle is a welfare gain going spare rather than a loss already suffered.
Merit goods are goods that are good for you and for society, but that people under-consume because they do not fully see the benefits.
Merit goods are under-provided by the market, but unlike public goods they are still provided in some amount, because firms can charge for them.
The fix is usually the opposite of the demerit good fix: subsidies, provision and education instead of taxes and bans.
Positive externalities of production
These appear while a good is being made, and the spillover benefit falls on other producers or on the wider community.
Take a firm that trains its staff to a very high standard. It pays the whole training bill, so its private costs are high. But those workers eventually move on, taking their skills to other employers who never paid a penny towards them. The same happens with a beekeeper whose bees pollinate every orchard for miles, and with a firm whose research becomes public knowledge.
Because society picks up a benefit the firm never charged for, the true cost to society of one more unit is lower than the cost the firm faces. So MSC lies below MPC.
The spillover is on the producer side, so there are two cost curves. Society would like more of this good than firms are willing to supply on their own, so the shaded triangle is a gain that is available but not being taken.
How to explain this diagram in an answer
The free market rests at PeQe, where MPB = MPC, because a firm can only act on the costs it actually pays.
The best point for society is PoptQopt, where MSB = MSC. That is a larger quantity at a lower price.
So there is under-provision of Qopt − Qe. Too few resources have gone into this industry.
The triangle shows the welfare society could gain if output rose to Qopt. It is a missed opportunity rather than damage done.
There is a case for intervention that makes it cheaper or easier to produce, such as a subsidy or a grant.
Positive externalities of consumption
These appear when a good is used, and they are the more common exam question. Vaccination is the perfect case. You get the private benefit of not falling ill. Everyone around you gets the benefit of not catching it from you, and they did not pay for your jab.
Education works the same way. A better educated population is more productive, pays more tax and commits less crime, and those gains are shared by people who never sat in the classroom. So the benefit to society is larger than the benefit the individual counts, and MSB lies above MPB.
Two benefit curves, one cost curve. Buyers only weigh up what they personally get, so they stop buying at Qe, well short of the quantity that would be best for everyone.
How to explain this diagram in an answer
The market clears at PeQe, where MPB = MPC.
Society’s best point is PoptQopt, where MSB = MSC, which is a larger quantity at a higher price.
There is under-consumption equal to Qopt − Qe.
The shaded triangle is the welfare society is leaving on the table.
More factors of production should be allocated to this good, which is the exact opposite of what you write for a demerit good.
A neat way to remember the direction: with a positive externality the market is being too shy. It stops early. So Qopt always sits to the right of Qe, and the arrow on the externality gap points towards the bigger quantity.
Merit goods
A merit good is a good that is beneficial to the person consuming it and to society, but which people buy less of than they should. Vaccinations, schooling, dental check-ups, insulation, sports facilities and public libraries all count.
There are two separate reasons why the market under-provides them, and strong answers separate the two:
People do not see the full benefit. A teenager does not feel the value of a pension or a dental check in twenty years’ time, so their MPB is lower than the true benefit.
People cannot afford them. Firms charge a profitable price, and lower income households are priced out even though the good would help them most.
Merit goods are not public goods. A private firm can sell you a school place or a dental appointment, because it can shut the door on people who do not pay. So merit goods are under-provided, not un-provided. Public goods are the ones a firm cannot sell at all, and you will meet those in the last page of this sub-topic.
Measuring the potential welfare gain
The maths is identical to the negative externality case. The triangle has its point at Qopt and its flat side at Qe, and the height is the gap between the two curves measured at Qe.
Potential welfare gain
Welfare gain = ½ × base × height
WORKED EXAMPLE
In a market for flu vaccinations, MPB = 40 − Q, MSB = 55 − Q and MPC = MSC = 10 + Q, with Q in thousands of doses. Find the under-consumption and the potential welfare gain. [4]
Step 1: free market, private curves only40 − Q = 10 + Q, so 30 = 2Q and Qe = 15Step 2: social optimum, social curves55 − Q = 10 + Q, so 45 = 2Q and Qopt = 22.5Under-consumption = 7.5 thousand dosesStep 3: height of the triangle at Qe = 15MSB = 55 − 15 = 40 and MSC = 10 + 15 = 25height = 40 − 25 = 15Step 4: area½ × 7.5 × 15 = 56.25Potential welfare gain = $56,250The external benefit is a flat $15 per dose, which is the vertical distance between MPB and MSB.
WORKED EXAMPLE
A town council says solar panels on homes create an external benefit of $600 per installation. The free market installs 4,000 panels a year and the socially optimum number is 5,500. Calculate the potential welfare gain. [2]
Step 1: base of the trianglebase = 5,500 − 4,000 = 1,500 panelsStep 2: height at QeA constant external benefit means the gap between MPB and MSB is the same everywhere.height = $600Step 3: area½ × 1,500 × 600Potential welfare gain = $450,000This is what the town gains if it can move installations all the way to Qopt, so treat it as a best case, not a promise.
💡 Exam tip
Call the triangle a potential welfare gain, not a welfare loss. It is welfare that could still be picked up, and using the right words shows you understand the direction.
Say who the third party is. “Classmates who do not catch the illness” beats “society benefits” every time.
Draw the arrow from the private curve to the social curve. It shows the size of the externality and helps you find the triangle.
Link merit goods to equity as well as efficiency. Under-consumption often hits lower income households hardest, which is a strong evaluation point.
Remember there is still a case for doing nothing. Subsidies cost money, and that money has an opportunity cost.
Keep the labels tidy. With a consumption externality the supply curve is S = MPC = MSC, and forgetting the double label loses marks.
⚠️ Common mix-up
Putting MSB below MPB for a positive externality. Extra benefit means the social curve is higher. Sketch the arrow upwards before you draw the line.
Assuming positive externalities are not a problem. They are still market failure. The market is still allocating the wrong amount of resources.
Mixing merit goods with public goods. Merit goods can be sold and are under-provided. Public goods cannot be sold and are not provided at all.
Saying merit goods are cheap. They are often expensive, which is part of why they get under-consumed.
Shifting demand instead of drawing a second demand curve. Nothing has moved. MSB was always there. The market simply never counted it.
Forgetting the production version exists. Training and research spillovers come up in Paper 1 essays, and most students only revise the consumption diagram.
Up next: Common Pool Resources and the Tragedy of the Commons, where the market failure comes not from a spillover but from the fact that nobody owns the thing being used.
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