A positive externality exists when you do something that provides a benefit to somebody else but that person doesn’t do anything to reward you for what you’ve done. You don’t get any reward, you don’t get any payment or anything even though you’ve provided that person with a benefit. Let’s say that you live next door to a person and you decide that you want to plant some beautiful flowers in your garden. You make these beautiful flowers and your neighbor happens to be selling their home. So they have a for sale sign up and people come by to look at your neighbor’s home and they say “Wow! look at this beautiful property next door, I think I would really like to live here this is such a nice neighborhood.” You have provided some benefit to your neighbor. They might be able to sell their home for more if you do a good job taking care of your home. However, you’re not compensated by your neighbor you can’t go over and say “Hey look what a great job I did maintain my lawn, I really think you should give me $500 bucks.” it doesn’t work that way. So you’ve provided some benefit but you haven’t reaped any reward for what you’ve done.
So let’s take an example of education. So education is a common example of a positive externality, I want to graph this out so you can see exactly the nature of the externality. Let’s say that x-axis is price and then we’ve got quantity in the y-axis and we could think about quantity as being the number of college graduates. So the number of people graduating from college or something in a given year so we’ll think about that is our quantity of education. Now we can look and say there’s a marginal social cost curve that maps out the marginal social cost. It’s the cost of providing one additional college graduate to society, there’s a cost there’s tuition and so forth but then we can also think about we can think about the marginal social benefit or the demand curve. The interesting thing is that is demand and so there’s some social benefit there’s some incremental benefit that we get as a society and this is the social benefit to all of our society from having more college graduates.
But when an individual person is deciding that “I want to become a college graduate or not.” They are thinking about their own costs and benefits, they’re only thinking about “If I decide to go to college I could have higher wages, I could have higher income, we’ll have hopefully more knowledge.” and so they’re thinking about the benefits that they’re going to get and there’s nothing wrong with that they’re just thinking about “What are the benefits in it for me if I decide to go to college because it’s gonna cost me money it’s gonna cost me time and so forth.” So this person is considering their private benefits we can think about increased wages and so forth as their private benefits. Now we can map those out as well we can say what is the marginal private benefit to a person of becoming a college graduate? Let’s say that we have a marginal private benefit curve and our socially efficient level would be where marginal social cost equals marginal social benefit. So this would be socially efficient and the quantity of college graduates let’s say that it’s 10 million people or something let’s just throw out a number there. Now the actual amount produced by the free market would be something less than the socially efficient or socially optimal number of college graduates and let’s just say that’s 7 million this is the amount which is produced. This 7 million is not efficient but it’s the one which is the equilibrium this is what the market creates is 7 million college graduates.
The reason is is that when we think about the quantity of 7 million, if we think about price and I know it’s hard to think about price in terms of the benefit of a college education and so forth but let’s just say we could put a number on it by increased wages and so forth. There’s a more marginal social benefit than marginal private benefit but that person in our example, when that individual is deciding “Let me weigh the costs and benefits are going to college.” They’re only thinking about their private benefits they’re not thinking about social benefits which include the private benefit plus external benefits those are benefits to people other than the person going to college. For example, let’s say that this person goes to college and graduates from college now they’re less likely to commit a crime. There’s going to be the more people that graduate college theoretically there will be less likely to engage in crime and so because they don’t engage in crime that’s a benefit to them, of course, they don’t have to go to jail or suffer any consequences but it’s also a benefit to all of us because we’re less likely to be the victim of a crime committed by this person.
But when this person is making the decision of “What are the costs and benefits of me going to college.” They’re not thinking about other people would be less likely to be the victim of a crime that he committed at some point. So they’re not considering the marginal social benefit and the social benefit includes both private benefits and external benefits, they’re only considering their own private benefit, the marginal private benefit to going to college and that’s why we have this situation where we end up with an inefficient number of college graduates and so it’s basically because the marginal social benefit is actually greater than the marginal private benefit for the person but the person has no incentive.
The person there’s no incentive for the person to say “What about the reduced crime for everybody else and so forth.” they’re not thinking about those things and so what’s going to happen is that education is going to be undersupplied that’s what we’re talking about when we say that this the socially efficient amount of college graduates would be 10 million but the actual amount is 7 million. So we’re short by 3 million, education is being undersupplied here and so there are a number of ways that the government could come in and say hey that we’ve got a market failure we need to do something, for example, they could subsidize education and in fact, that’s what many countries do and we’ll talk about that in another article.