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Positive externalities

What Is Positive Externalities?

Positive externalities occur in economics when the production or consumption of a good or service generates a benefit for a third party not directly involved in the transaction. These uncompensated benefits spill over to others, meaning that society as a whole receives more benefit than the private individuals or firms involved in the activity. This divergence between private and social benefits represents a form of market failure, as the free market tends to underproduce goods and services that generate such external advantages30, 31. Understanding positive externalities is crucial within the broader field of economics, particularly welfare economics, as they highlight situations where market outcomes are not economic efficiency.

History and Origin

The concept of externalities, including positive externalities, was formally developed by British economist Arthur C. Pigou in his seminal 1920 work, The Economics of Welfare. Building on ideas from his mentor Alfred Marshall, Pigou articulated how costs or benefits not accounted for by the person undertaking an action could impact others27, 28, 29. Pigou argued that these external effects, whether positive or negative, could justify government intervention to correct market inefficiencies. For positive externalities, he advocated for government subsidies to encourage activities that yielded broader societal gains, a policy approach now often referred to as Pigouvian subsidies24, 25, 26. His analysis laid the groundwork for modern discussions on how to achieve socially optimal outcomes in the presence of external benefits.

Key Takeaways

  • Positive externalities are uncompensated benefits that accrue to a third party as a result of an economic transaction.
  • They lead to a situation where the marginal social benefit of an activity exceeds its marginal private benefit.
  • Markets tend to underproduce goods and services that generate positive externalities because private actors do not capture the full societal value.
  • Examples include education, research and development, and vaccinations.
  • Government policies, such as subsidies, are often proposed to encourage the production or consumption of goods with positive externalities, aiming to increase overall societal welfare.

Formula and Calculation

While there isn't a single "formula" for calculating a positive externality's absolute value, the concept is understood by comparing private benefits and social benefits. In the presence of a positive externality, the marginal social benefit (MSB) derived from an activity is greater than the marginal private benefit (MPB) received by the direct consumer or producer. This relationship can be expressed as:

MSB>MPBMSB > MPB

The vertical difference between the MSB and MPB curves at any given quantity represents the value of the positive externality. This difference indicates the additional benefit flowing to society beyond what the individual decision-maker considers23.

Interpreting Positive Externalities

When analyzing positive externalities, the primary interpretation is that the free market, left to its own devices, will produce less of the good or service than is socially optimal. This underproduction occurs because the market price only reflects the private benefits and costs, failing to account for the additional advantages enjoyed by third parties20, 21, 22. For instance, an individual deciding whether to pursue higher education primarily considers their personal career prospects and earnings. However, a more educated populace can lead to a more innovative workforce, lower crime rates, and more informed civic engagement—benefits that extend far beyond the individual, leading to greater societal economic efficiency. Correcting this underproduction often involves policy interventions designed to "internalize" the externality, meaning to make the decision-makers account for the broader societal benefits. 19This typically pushes the market output closer to the socially optimal market equilibrium.

Hypothetical Example

Consider a beekeeper who sets up hives near an apple orchard. The beekeeper's primary goal is to produce honey for sale, generating a private benefit from their efforts. However, as the bees collect nectar from the apple blossoms, they also pollinate the apple trees. This pollination significantly increases the apple farmer's yield and fruit quality, providing a substantial, uncompensated benefit to the farmer.

In this scenario, the pollination service provided by the bees is a positive externality of the beekeeper's honey production. The beekeeper does not directly charge the apple farmer for this service, nor is the apple farmer paying for it. If the beekeeper only considers the profitability of honey production, they might keep fewer hives than would be optimal for both honey production and apple yield combined. This illustrates how the interaction of supply and demand based solely on private incentives can lead to a less-than-optimal outcome from a broader societal perspective. A cost-benefit analysis from a societal standpoint would show that more hives, leading to more pollination, would be beneficial for both parties and the economy at large.

Practical Applications

Positive externalities are observed across various sectors of the economy and often serve as a rationale for public policy. One prominent area is research and development (R&D). When companies invest in R&D, they not only develop new products or processes that benefit them privately but also contribute to a broader pool of knowledge and technology from which other firms and society can benefit, known as "knowledge spillovers". 16, 17, 18Governments often use subsidies or tax incentives to encourage R&D spending, aiming to foster innovation that benefits the entire economy.
15
Public health initiatives also exemplify positive externalities. For instance, widespread vaccination against infectious diseases not only protects the vaccinated individual (private benefit) but also contributes to "herd immunity," reducing the spread of the disease to those who cannot be vaccinated (social benefit). This reduction in disease burden is a significant positive externality, benefiting the entire community's health and economic productivity. 13, 14Similarly, investments in education yield positive externalities through a more skilled workforce, increased civic participation, and lower crime rates, prompting government funding for schools and universities. 12The Federal Reserve Bank of St. Louis, for example, highlights the economic benefits derived from public health improvements, underscoring their broad societal impact. The Economics of Public Health.

Limitations and Criticisms

While positive externalities provide a clear justification for intervention to enhance societal well-being, their practical implementation faces challenges. One significant limitation is the difficulty in accurately measuring the magnitude of external benefits. 11Quantifying the precise social benefits of something like a new technology or a general education level can be complex, making it hard to determine the optimal level of government intervention or the appropriate size of a subsidy. 10Overestimating these benefits could lead to inefficient allocation of resources or excessive government spending.

Another criticism relates to the potential for the "free-rider problem," particularly in the context of public goods or services that generate positive externalities. Individuals or firms may benefit from the externality without contributing to its production, reducing the incentive for private entities to provide the good or service. 9Furthermore, even with government intervention, policies designed to promote positive externalities might not always be effective or might lead to unintended consequences. For instance, questions can arise regarding whether government spending on research and development genuinely stimulates economic growth as efficiently as private investment. The Cato Institute, for example, has published analyses questioning the effectiveness of government R&D spending in stimulating economic growth. Does Government Spending on Research and Development Stimulate Economic Growth?.

Positive Externalities vs. Negative Externalities

The distinction between positive and negative externalities lies in the nature of their impact on third parties. Both represent instances of market failure where the price mechanism fails to fully account for all societal costs or benefits. However, positive externalities occur when an economic activity confers uncompensated benefits on others, leading to an underproduction of the good or service from a societal perspective. 6, 7, 8Examples include the societal benefits from education or research and development.

Conversely, negative externalities arise when an economic activity imposes uncompensated costs on third parties, leading to an overproduction of the good or service. Pollution from a factory, where the environmental and health costs are borne by the public rather than fully by the factory, is a classic example. While positive externalities typically call for policies like subsidies to encourage more of the activity, negative externalities often necessitate taxes or regulations to curb the activity to a socially optimal level.

FAQs

What are some common examples of positive externalities?

Common examples of positive externalities include vaccinations, which protect both the vaccinated individual and the community by reducing disease transmission; education, which leads to a more skilled workforce and informed citizenry; and research and development in new technologies, whose benefits often spill over to other industries and society as a whole.
4, 5

Why do positive externalities lead to market underproduction?

Positive externalities lead to market underproduction because the individuals or firms undertaking the activity do not capture the full social benefits of their actions. They only consider their own private benefits when making decisions, resulting in a level of production or consumption that is less than what would be optimal for society.
3

How do governments address positive externalities?

Governments typically address positive externalities through policies designed to encourage the production or consumption of the beneficial good or service. This can include offering subsidies (like funding for education or R&D grants), providing tax incentives, or directly supplying the good as a public good (e.g., public health campaigns or infrastructure projects). 1, 2The goal is to align private incentives with societal welfare, moving towards greater economic efficiency.