Positive Externalities

If you chose to plant hedges around your house instead of building a wooden or concrete fence, you would think that this decision only affected you. But, the decision to plant hedges around your house actually has positive externalities as plants filter the air we breathe. Yep, in this case, the positive externality is how your decision to plant hedges around your house affected practically everybody breathing air. But what are the causes, and how do we measure positive externalities? How can we present a positive externality on a graph? What are real-world examples of positive externalities? Read on, and let's learn together!

Positive Externalities Positive Externalities

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Table of contents

    Positive Externality Definition

    A positive externality is a good thing that happens to someone because of something someone else did, but they don't have to pay for it. For example, if your neighbor plants beautiful flowers in their front yard, your street looks nicer even though you didn't pay for the flowers. In economics, we talk about externalities as a consequence of producing or consuming goods and services.

    A positive externality occurs when the actions of a producer or consumer have positive effects on people who are not involved in the market transaction, and these effects are not reflected in market prices.

    A local restaurant owner decides to invest in cleaning up the town's main park and installing new playground equipment for children. While the restaurant owner may not directly benefit from the park renovation, the increase in tourism from families with young children who come to use the new playground will benefit the town's economy as a whole. This is an example of a positive externality because the restaurant owner's investment in the park benefits the community beyond what they intended or are compensated for.

    The concept of externalities is such that when a person makes an economic decision, that decision affects not only the person making the decision but also other people in the market or economic environment.

    As you probably already guessed, if there are positive externalities, there should also be negative externalities. You are right! A negative externality refers to how the actions of one party result in a cost to other parties.

    A negative externality refers to the cost of the actions of one party to the well-being of other parties.

    Read our article on Externalities to learn even more about externalities in general!

    Positive Externality Causes

    The main cause of a positive externality is a spillover of benefits. In other words, when a person makes an economic decision, and the benefit is not limited to the decision-maker, but other people benefit as well, there has been a positive externality.

    When an economic action is taken, it has a private cost and social cost, as well as a private benefit and social benefit. So, what are these? A private cost is a cost incurred by the party who makes an economic decision, whereas the social cost also includes the cost incurred by society or bystanders as a result of the decision made by one party.

    Similarly, a private benefit is a benefit gained by the party who makes an economic decision, whereas a social benefit also includes the benefit to society or bystanders as a result of that person's economic decision. A positive externality is essentially a part of social benefits.

    Private cost is the cost incurred by the party who takes an economic action.

    Social cost refers to the costs incurred by the party who takes an economic action, as well as by bystanders or society, as a result of that action taken.

    Private benefit is the benefit to the party who takes an economic action.

    Social benefit refers to the benefits to the party who takes an economic action, as well as to bystanders or society, as a result of that action taken.

    • The main cause of a positive externality is a spillover of benefits.

    Private benefit and social benefits may also be referred to as private value and social value, respectively.

    Positive Externality Graph

    Economists illustrate positive externalities using the positive externality graph. This graph shows the demand and supply curves at the market equilibrium and at the optimum equilibrium. How? Shall we look at Figure 1 below?

    Positive externalities Positive externality graph StudySmarterFig. 1 - Positive externality graph

    As Figure 1 illustrates, if left alone, agents in the market will pursue private benefits, and the prevailing quantity will be QMarket at the private market equilibrium. However, this is not optimal, and the socially optimal quantity is QOptimum which creates the socially optimal equilibrium as the demand shifts to the right to accommodate the external benefit. At this point, society is gaining full benefits from the market.

    Negative Externality Graph

    Let's have a look at the negative externality graph in Figure 2, which shows a shift in the supply curve to accommodate the external costs.

    Positive externalities Negative externality graph StudySmarterFig. 2 - Negative externality graph

    As shown in Figure 2, producers will ignore the external costs if left alone and produce a higher quantity (QMarket). However, when external costs are taken into consideration, the supply curve shifts to the left, reducing the quantity to QOptimum. This is because when the external cost of production is added, it costs more to produce, and therefore less will be produced.

    Negative externalities are undesirable, especially when social costs exceed private costs. When social costs exceed private costs, this means society bears the burden for an individual or firm to enjoy the benefits. In other words, the individual or firm enjoys or profits at the expense of society.

    To learn what negative externalities entail in detail, read our article:

    - Negative Externalities.

    Positive Externality of Consumption

    Now, we will discuss the positive externality of consumption, which refers to the positive externality resulting from consuming a good or service. Here, we will use the example of beekeeping, which typically benefits society as a whole. Let's use the following example to make things easier to understand.

    A beekeeper keeps bees for the primary purpose of harvesting their honey. However, bees fly around and help the environment by facilitating pollination. As a result, the beekeeper's activities have the positive externality of pollinating plants, which humans can't live without.

    All in all, some goods and services have positive externalities associated with their consumption. This is because, as consumed, they provide benefits beyond those the direct consumer enjoys.

    Read our article on Pigouvian Tax to learn about how the government corrects negative externalities!

    Positive Externality Examples

    Most common examples of positive externalities:

    • Education: Consuming education allows an individual to contribute to society in many ways, such as by creating new inventions, sharing knowledge and ideas, and producing higher-quality work.
    • Green spaces: Public parks and green spaces benefit the individuals who use them for recreational purposes and the surrounding community.
    • Research and development: Technological advancements that result from research benefit the companies and individuals that invest in them and positively affect society as a whole.

    Now, we will look at examples of positive externalities in more details.

    Samantha's family decides to plant trees in their front yard to provide shade since the summers in their town can be very hot. They go ahead to plant the trees, which they benefit directly from in the form of the shade it provides. The trees also help the environment by using up excess carbon dioxide, purifying the air for the whole community.

    In this example, the trees provide shade to Samantha's family as a private benefit, and it purifies the air for everybody else as an external benefit.

    Let's look at another example.

    Eric studies engineering at university and graduates. He then establishes an engineering firm, which gets a contract from the government to build roads in his community.

    From the example above, Eric's private benefit for consuming education is the ability to establish his firm and the money received for the contract from the government. However, the benefit does not end there. The community also benefits because Eric's engineering firm employs people and helps reduce unemployment. The road Eric's firm will build will also make transportation easier for the whole community.

    Positive externalities and the government

    Sometimes, when the government realizes that a particular good or service has high positive externalities, the government intervenes in the market to ensure that more of that good or service is produced. One of the ways through which the government does this is the use of subsidies. A subsidy is a benefit, often monetary, given to an individual or business to produce a particular good.

    A subsidy is a benefit (often money) given to an individual or business to produce a particular good.

    A subsidy encourages producers to produce specific goods that have a high social benefit. For instance, if the government subsidizes education, it will be more accessible, and society will end up enjoying the external benefits associated with education.

    Positive Externalities - Key takeaways

    • An externality refers to the uncompensated influence of the actions of one party on the well-being of other parties.
    • A positive externality refers to the benefit of the actions of one party on the well-being of other parties.
    • A private cost is a cost incurred by the party who makes an economic decision, whereas the social cost also includes the cost incurred by society or bystanders as a result of the decision made by one party.
    • A private benefit is a benefit gained by the party who makes an economic decision, whereas a social benefit also includes the benefit to society or bystanders as a result of that person's economic decision.
    • The socially optimal demand curve lies to the right of the private market demand curve.
    Frequently Asked Questions about Positive Externalities

    What is the difference between a positive externality and a negative externality?

    A positive externality refers to the benefit of the actions of one party to the well-being of other parties, whereas a negative externality refers to the cost of the actions of one party to the well-being of other parties.

    What is the definition of an externality?

    An externality refers to the uncompensated influence of the actions of one party on the well-being of other parties.

    What's an example of a positive externality?

    Eric studies engineering at university and graduates. He then establishes an engineering firm, which employs people in his community. The positive externality of Eric's consumption of education is the jobs his firm now provides.

    How do you graph a positive externality? 

    The positive externality graph shows the demand and supply curves at the market equilibrium and at the optimum equilibrium. First, we draw the private market demand curve, then we draw the socially optimal demand curve, which lies to the right of the private market demand curve.

    What is a positive production externality?

    A positive production externality is the benefit of the production activities of a firm to third parties.

    What is a positive externality of consumption?

    The positive externality of consumption refers to the positive externality resulting from consuming a good or service. For example, if you buy and use (consume) an electric car, you will reduce the carbon emission in your city which will be beneficial for everyone around you.

    Test your knowledge with multiple choice flashcards

    When a person makes an economic decision, and the benefit is not limited to the decision-maker, but other people benefit as well, there has been a positive externality.

    The main cause of a positive externality is a spill-over of costs.

    A benefit (often money) given to an individual or business to produce a particular good is known as?

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