Marginal External Benefit Explained
By Steve Bain
A marginal external benefit, also known as a positive externality, occurs whenever the consumption or production of a good/service leads to benefits that are captured by the wider population i.e. external to the buyer's or the seller's gains from a trade.
In practice, we are only concerned with those situations in which the marginal external benefit is large enough to matter. There are almost certainly some positive externalities associated with almost all products, but they are usually too minor to make a significant impact on market outcomes.
There are other cases where there is a significant external benefit associated with a product, but there is still insufficient cause for any corrective action because the costs of such action is prohibitive. No market is perfect, but that in itself is not a justification for intervention, and we always need to take account of the costs of any intervention.
This is one of our greatest mistakes in economics, because the urge to take action wherever an inefficiency presents itself is great, and the law of unintended consequences is easy to dismiss.
Marginal External Benefit & Marginal Social Benefit
The marginal external benefit curve (MEB) is directly linked to the marginal social benefit curve (MSB). In the graph below this is clearly illustrated, and the difference between the two is equal to the marginal private benefit curve (MPB).
For a firm in a competitive market, P=MR=MPB=Demand.
This is simply the price line, because the marginal revenue curve for a competitive firm is equal to the market price, which in turn is equal to MPB and the demand curve. This is because competitive firms have no market power to influence prices, and simply accept the going rate.
In the graph the going rate is P, and it is horizontal indicating that no matter what level of production the competitive firm chooses to supply, it will not be a large enough proportion of the total industry supply for the firm to be able to affect the price.
Marginal External Benefit Formula
Since MSB is, by definition, equal to MPB + MEC, we can do a very simple rearrangement of this equation to derive the marginal external benefit formula:
MEB = MSB - MPB
(Remembering that MPB is equal to MR, price, and demand in a competitve industry.)
Mastering the equations above is not essential for your understanding of the concept involved here, and even when mastered they are quickly forgotten. For this reason I prefer to use graphs to illustrate these relationships since the visual aspect is immediately apparent and more memorable.
The same sort of analysis applies for non-competitive markets, but in that case the demand curve will not be a horizontal price line and MR will differ from price. However, in all cases (competitive or not) the MPB curve is equal to the demand curve and price, so MEB will always be equal to MSB minus MPB.