What are positive externalities of consumption? Explain with a diagram and give an example.

Externalities are effects that occur, due to a transaction, on third parties (people who were not involved in the original transaction). Hence, positive externalities of consumption are produced when the consumption (use) of a good has positive effects on third parties. Examples of this could include the consumption of vaccinations. When I consume a vaccine I decrease the chance of me passing on diseases to the wider population, therefore third parties are less likely to get ill. Goods like these with positive externalities are called merit goods.

Unfortunately often the market does not take these externalities into account, creating market failure. Market failure is when the free market does not allocate resources in the socially optimal (Qso) way. In the case of a positive externality of consumption the marginal social benefit (MSB) of consuming a good and the marginal private benefit of consuming a good (MPB) will be different, as private benefit does not consider third party benefits. We can show this on a price-quantity diagram: MSB will be further right than MPB and market failure will occur, with the welfare loss shown as the shaded triangle. Within our vaccine example the welfare loss would be the increased likelihood of people in society getting a disease.