In this lesson, we’ll explore the marginal benefit to society that occurs with an economic transaction. We’ll analyze how positive externality impacts the demand curve and price, then learn how the benefit to a population can be subsidized.
Defining Positive Externality
Positive externality is the benefit to a third-party during an economic transaction. For example, when you make a purchase or an investment, such as pursuing a college education, did you know others may benefit socially, even though they may not share in the cost? Social benefits include those received by anyone other than a party to an economic transaction.
So, because others may benefit from your investment in a college education, should the price of tuition go up to reflect its true value?Positive externality refers to the part of a transaction that takes place above the equilibrium of supply and private quantity demanded. Some terms used to describe positive externality include free-riding, where some people pay less and use more of shared resources, and social welfare. Positive externalities cause a demand-side market failure, as producers shift resources away from producing the optimal supply. As the benefits of positive externality do not encourage producers to increase output, demand is not met with supply.
Positive Externality: A Real-Life Example
Let’s imagine that you’ve decided to build a privacy hedge at the back of your property to block the view of an unsightly landscape.
If you extended the hedge to your front yard, your beautiful hedge would increase the value of other homes in the neighborhood. Although you wanted the hedge and assumed all of the costs of installing it, your neighbors receive third-party benefits in that the value of their homes will increase if you add a hedge to your front yard. The resulting positive externality is known as the marginal benefit.The following graph can help you understand how marginal benefit impacts the demand curve and supply cost. To help you interpret the graph, use the symbols identified below.
Q-1: The hedge in your backyardQ-O: Optimal quantity, or the hedges in your front and backyardD-1: Your private demand for the hedgeD-T: The total demand for the hedge, including its marginal benefitP-1: The price you pay for the quantity demandedP-O: The price charged to produce optimal quantity
Subsidizing the Marginal Benefit
At the point of optimal equilibrium, the price will rise to an attractive level, and vendors will increase supply. As a private homeowner, you do not need to increase the value of the homes around you by building an additional hedge. However, you could be encouraged to act in your neighbors’ best interests through a subsidy designed to increase the quantity demanded and provide a marginal benefit.For instance, either your neighborhood association or a third-party, like your local government, may decide to provide you with a subsidy. To achieve optimal equilibrium, your neighborhood association may agree to subsidize the cost of an additional hedge. By comparison, your local government would need a compelling reason to increase the values of private homes, and therefore, be unlikely to subsidize the additional hedge.
Sometimes, the government offers subsidies to promote a positive externality for the public good. For instance, education, infrastructure, disease management, historic preservation, and land conservation are some areas where the government will use public funds to provide a social good for the benefit of a population.Government may subsidize education to produce a more employable workforce and reduce unemployment.
Infrastructure, including roads and bridges, may be subsidized through bonds, fuel taxes, or local tax levies. Subsidizing the management of communicable disease, including screenings, immunizations, and treatments, may lead to fewer incidents of disease. Land conservation may allow for subsidies to private landowners, effectively preventing the land from being over-planted.
For example, in Kentucky, over half a billion dollars was paid to a Conservation Reserve Program (CRP) from 1995- 2012. During that same period, the United States distributed $177.6 billion in commodity subsidies and $84.4 billion in corn subsidies to protect the farm industry.Governments also provide subsidies to introduce a good or service into the market. Whichever the reason, the intent is to meet the optimal equilibrium.
Positive externality is the marginal benefit received by a third party as the result of an economic transaction.
It also refers to the portion of a transaction that takes place above the equilibrium of supply and private quantity demanded. On a graph, the demand curve shifts to the right, where quantity demanded and supply are higher at the point where a positive externality exists. For the benefit of the public, the government sometimes provides subsidies for educational, health, or infrastructure projects, or to encourage vendors to produce more of a good or service.