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Positive Externality: Definition & Examples

Instructor: Ellie Funke
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 backyard

Q-O: Optimal quantity, or the hedges in your front and backyard

D-1: Your private demand for the hedge

D-T: The total demand for the hedge, including its marginal benefit

P-1: The price you pay for the quantity demanded

P-O: The price charged to produce optimal quantity

Notice how the demand curve shifts up and to the right
Positive externality of privacy hedge

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.

Government Subsidies

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.

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