Positive externalities

A positive externality is a benefit that is enjoyed by a third-party as a result of an economic transaction. Third-parties include any individual, organisation, property owner, or resource that is indirectly affected. While individuals who benefit from positive externalities without paying are considered to be free-riders, it may be in the interests of society to encourage free-riders to consume goods which generate substantial external benefits.

Most merit goods generate positive consumption externalities, which beneficiaries do not pay for. For example, with healthcare, private treatment for contagious diseases provides a considerable benefit to others, for which they do not pay. Similarly, with education, the skills acquired and knowledge learnt at university can benefit the wider community in many ways.

Unlike the case of negative externalities, which should be discouraged to achieve a socially efficient allocation of scarce resources, positive externalities should be encouraged.

Encouraging positive externalities

One role for government is to implement economic policies that promote positive externalities. There are two general approaches to promoting positive externalities; to increase the supply of, and demand for, goods, services and resources that generate external benefits.

Increasing supply

Government grants and subsidies to producers of goods and services that generate external benefits will reduce costs of production, and encourage more supply. This is a common remedy to encourage the supply of merit goods such as healthcare, education, and social housing. Such merit goods can be funded out of central and local government taxation. Public goods, such as roads, bridges and airports, also generate considerable positive externalities, and can be built, maintained and fully, or part, funded out of tax revenue.

Increasing demand

Demand for goods, which generate positive externalities, can be encouraged by reducing the price paid by consumers. For example, subsidising the tuition fees of university students will encourage more young people to go to university, which will generate a positive externality for future generations.

The ultimate encouragement to consume is to make the good completely free at the point of consumption, such as with freely available hospital treatment for contagious diseases.

Government can also provide free information to consumers, to compensate for the information failure that discourages consumption. If individuals are fully informed about the benefits of consuming goods and services that generate external benefits, they may develop a better understanding of the product and demand more of it. For example, public information broadcasts, such as aids awareness programmes, can reduce ignorance, and encourage the use of condoms.

An additional option is to compel individuals to consume the good or service that generates the external benefit. For example, if suspected of having a contagious disease, an individual may be forced into hospital to receive treatment, even against their will. In terms of education, attendance at school up until the age of 16 is compulsory, and parents may be fined for encouraging their children to truant. 

Net welfare loss

The existence of a positive externality means that marginal social benefit is greater than marginal private benefit. For example, in considering the market for education, free markets would supply quantity Q at price P. If the external benefit is included, the socially efficient output rises to quantity Q1.

By consuming only quantity Q, marginal social benefit is above marginal social cost, and more of the good should be consumed. At Q, the marginal social cost is A (Q – A), and the private benefit is also A (Q – A) but the marginal social benefit is C (Q – C). Therefore, if only Q is consumed, there is an opportunity cost to society, which is represented by the area of welfare loss, A, C, B.

Positive production externalities

A positive production externality occurs when a third party gains as a result of production. However, those third parties who benefit cannot be charged, so there is only an incentive to supply to those who can be charged.

Positive production externalities occur in many situations, most notably with the construction and operation of infrastructure projects, such as a new airport, or motorway.

Research and development which leads to new technology is also a potential by-product of production, which other firms can benefit from.

Firms usually try to protect their inventions, but new technologies can quickly become shared and generate widespread benefits.

The technology developed alongside the internet, such as the HTML language, is now the standard text editor for commercial websites.