Will the free market produce the socially desired amount of a good when positive externalities are present?

• A. Yes
• B. No
• C. Sometimes
• D. Only with government intervention

Answer: (B)

Positive externalities occur when people receive benefits from an action that others pay for but don’t themselves capture. In a free market, decisions are based on private benefits and private costs. Since the social benefit includes benefits to third parties and is therefore larger than the private benefit, the market will produce where private marginal benefit equals marginal cost, which is below the level where marginal social benefit equals marginal cost. So the free market underproduces relative to the socially desired amount. To reach that level, some form of intervention or incentive is typically needed to raise production toward the social optimum.