Positive externality

Economists use the term externality to describe any time the price determined by a market doesn't reflect the true cost of an action. A positive externality is a good consequence that isn't taken into account.

An externality is an effect that an economic transaction has on a party who is not involved in the transaction.

Externalities deter a market from producing the equilibrium quantity and price for a good for service. Externalities produce inefficiencies in markets and can eventually produce a market failure if not internalized in time.

Positive Externality

A positive externality is something that enhances society as a whole. It results from an economic transaction that has positive external effects on others not party to the transaction.

One example of a positive externality is the market for education. The more education a person receives, the greater the social benefit since more educated people tend to be more enterprising, meaning they bring greater economic value to their community.

Effect of Education on the Market

Figure 1. The effect of higher education on society.

The social benefit (SD) of obtaining higher education is greater than that of the private benefit (D). Because individuals do not factor in the social benefit, they are only interested in the private benefit and therefore they purchase a level of education which is not socially optimal.

• At Point A the level of education is below the socially desirably level and confers only a private benefit to the person.
• The red triangle #1 & #2 represent the deadweight loss that results from this decision not to obtain a socially desirable educational level.
• At Point B the level of eduction increases as does the cost.
• The increase in education creates a benefit beyond just the private benefit to the person, this is called the external marginal benefit (EMB).
• The EMB is the amount of benefit that is conferred to society as a result of the higher level of education.
• The red triangle #1 represents the deadweight loss that results from this decision to obtain a socially desirable educational level. It is only half the amount from before.
• This deadweight loss exists because in a perfect market, every person would obtain the exact level of education that they need but because this is almost impossible to do it is better to have everyone over-educated.

To increase the level of education, the government could offer an education subsidy which would lower the cost of education and encourage more people to obtain a higher level of education. This would close the gap between P₁ and P₂ and increase the output of higher education. Therefore the individuals could pay the same price before (accompanied by a subsidy) and the overall level of education would increase and maximize the social benefit.