After reading this article you will learn about the relationship between positive externalities and allocative efficiency.
Positive externality occurs whenever private markets fail to allocate resources on the basis of full social benefits. Immunization against communicable disease, external benefits from education at schools are typical examples of positive externalities. Individuals who are external to the market exchange are not required to pay for benefits they receive.
Positive externalities and allocative efficiency is explained with the following diagram:
When positive externalities are present marginal social benefits exceeds marginal private benefits (MSB > MPB). This is so because benefits derived from consumption of goods positively influence others who are not part of the market exchange. Figure 2.5 shows the private market for education.
Marginal private benefit of education flows directly to the person who get educated. Therefore when private market allocates resources into education, resources are allocated until, MPB = MSC at point E1.
However if the members of the society benefit from the educated citizenry at large, positive externalities are associated with the education market. Marginal external benefits that flow to society from educated citizenry are measured as MSB-MPB (i.e. distance ce at point E1. Therefore at E1 MSB > MPB.
Allocative efficiency however occurs at E2, where MSC = MSB. Hence the private market for education under produces education by E1 E2.
Subsidies are often used when private markets do not take full consideration of positive externalities.
In the figure a subsidy rate of fg at the optimal level of education E2 result in raising MPB up to MSB. Area abfg measures the tax subsidy that tax payers provide for education.
An externality is not simply an inter dependence between consumer and consumer. It is an interdependence that operates outside the price mechanism.
Government intervention can deal with the problem of externalities byway of tax. subsidy or a regulatory policy. The case for government intervention however depends upon the transaction costs associated with such activity and the costs in leaving the problem to the market mechanism.
The choice of fiscal instrument can be made on the basis of efficiency Comparison. A tax arrangement will always prove superior to a regularity arrangement when dealing with external diseconomies. However the real selection of fiscal tool to correct externalities is a matter influenced by political process.