Essay
Using diagrams, explain how a positive production externality creates a welfare loss
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Essay analysing how a welfare loss to society is caused by a positive production externality existing
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B928759 Page 144. An externality is where a third party who is not involved in a market transaction
incurs an external cost/benefit as a result of that transaction. A positive production
externality is where a third party incurs an external benefit as a result of the decision
to produce a good. An example of a good with positive production externality is a
pharmaceutical producing machine as it’s production means there are more
pharmaceuticals able to produced per unit time period and hence those who are ill
and require medicine externally benefit from the production of more pharmaceutical
producing machines. For the government it is important to know about
goods/services which have positive production externalities so it can intervene to
correct the market failure caused as a result of underproduction of the good with the
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positive externality.
The initial equilibrium with the free market allocation is at Qe and Private costs and
here the agents involved in the market transaction are not accounting for the external
benefit (MXB) of the third party not directly involved in the transaction of the
production of this good. As a result, there is a divergence of Marginal social benefit
(MSB) and Marginal social costs (MSC) and hence the current free market allocation
of resources at Qe is not at a socially efficient level as there is improvement to
society to be had by producing at Q*. Although the market is privately efficient at
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