Positive externalities are benefits caused by transactions that affect an otherwise uninvolved party who did not choose to incur that benefit. Externalities occur all the time because economic events do not occur within a vacuum. Transactions often require the use of common resources that are shared with parties are not involved with the exchange. The use of these resources, in turn, impacts the uninvolved parties.
In the case of positive externalities, a transaction has positive side effects for non-related parties. Let's take a look at some example:
- A homeowner keeps his house maintained, the neighborhood benefits through higher home values. The homeowner's neighbors benefit from a positive externality.
- A person may keep bees for her own enjoyment, but gardeners in the area benefit because their flowers are pollinated . The beekeeper's transaction of purchasing bees ends up positively affecting parties who are not involved in the transaction.
- A person becomes inoculated against a disease, those around him benefit because they cannot catch the disease from him. There was an exchange between the doctor and the patient, but others also benefit.
In each of these cases, the people taking action are presumably not doing it for the sake of the community, but for their own purposes. The people taking the action may also enjoy the additional benefits described above, but initiators of actions are not considered beneficiaries of externalities.
The problem with positive externalities is that the people who create these advantages cannot charge the beneficiaries; the beneficiaries can "free ride," or benefit without paying. For example, assume everyone in a community, except one person, got a flu shot. That one person could choose to abstain from receiving the shot; since everyone else got inoculated, he can't get the disease from the others because they can't catch the flu. That person would be a free rider since he would benefit from inoculations without incurring any cost.
Since parties that create the externality aren't compensated, they do not have any incentive to create more. This results in a suboptimal result, because the producers of the externality will generally create less of the benefit than the larger community needs.