10.3 Positive Externalities

New Jersey is the most densely populated state in the country, lying along the northeastern corridor, an area of almost continuous development stretching from Washington, D.C., to Boston. Yet a drive through New Jersey reveals a surprising feature: acre upon acre of farmland, growing everything from corn to pumpkins to the famous Jersey tomatoes. This situation is no accident: starting in 1961, New Jerseyans have voted in a series of measures that subsidize farmers to permanently preserve their farmland rather than sell it to developers. By 2013, the Green Acres Program, administered by the state, had preserved over 640,000 acres of open space.


Why have New Jersey citizens voted to raise their own taxes to subsidize the preservation of farmland? Because they believe that preserved farmland in an already heavily developed state provides external benefits, such as natural beauty, access to fresh food, and the conservation of wild bird populations. In addition, preservation alleviates the external costs that come with more development, such as pressure on roads, water supplies, and municipal services—and, inevitably, more pollution.

In this section we’ll explore the topics of external benefits and positive externalities. They are, in many ways, the mirror images of external costs and negative externalities. Left to its own, the market will produce too little of a good (in this case, preserved New Jersey farmland) that confers external benefits on others. But society as a whole is better off when policies are adopted that increase the supply of such a good.

Preserved Farmland: An External Benefit

Preserved farmland yields both benefits and costs to society. In the absence of government intervention, the farmer who wants to sell his land incurs all the costs of preservation—namely, the forgone profit to be made from selling the farmland to a developer. But the benefits of preserved farmland accrue not to the farmer but to neighboring residents, who have no right to influence how the farmland is disposed of.

Figure 10-4 illustrates society’s problem. The marginal social cost of preserved farmland, shown by the MSC curve, is the additional cost imposed on society by an additional acre of such farmland. This represents the forgone profits that would have accrued to farmers if they had sold their land to developers. The line is upward sloping because when very few acres are preserved and there is plenty of land available for development, the profit that could be made from selling an acre to a developer is small. But as the number of preserved acres increases and few are left for development, the amount a developer is willing to pay for them, and therefore the forgone profit, increases as well.

Figure 10.4: FIGURE 10-4 Why a Market Economy Preserves Too Little Farmland
Figure 10.4: Without government intervention, the quantity of preserved farmland will be zero, the level at which the marginal social cost of preservation is zero. This is an inefficiently low quantity of preserved farmland: the marginal social benefit is $20,000, but the marginal social cost is zero. An optimal Pigouvian subsidy of $10,000, the value of the marginal social benefit of preservation when it equals the marginal social cost, can move the market to the socially optimal level of preservation, QOPT.


The MSB curve represents the marginal social benefit of preserved farmland. It is the additional benefit that accrues to society—in this case, the farmer’s neighbors—when an additional acre of farmland is preserved. The curve is downward sloping because as more farmland is preserved, the benefit to society of preserving another acre falls.

As Figure 10-4 shows, the socially optimal point, O, occurs when the marginal social cost and the marginal social benefit are equalized—here, at a price of $10,000 per acre. At the socially optimal point, QOPT acres of farmland are preserved.

The market alone will not provide QOPT acres of preserved farmland. Instead, in the market outcome no acres will be preserved; the level of preserved farmland, QMKT, is equal to zero. That’s because farmers will set the marginal social cost of preservation—their forgone profits—at zero and sell all their acres to developers. Because farmers bear the entire cost of preservation but gain none of the benefits, an inefficiently low quantity of acres will be preserved in the market outcome.

A Pigouvian subsidy is a payment designed to encourage activities that yield external benefits.

This is clearly inefficient because at zero acres preserved, the marginal social benefit of preserving an acre of farmland is $20,000. So how can the economy be induced to produce QOPT acres of preserved farmland, the socially optimal level? The answer is a Pigouvian subsidy: a payment designed to encourage activities that yield external benefits. The optimal Pigouvian subsidy, as shown in Figure 10-4, is equal to the marginal social benefit of preserved farmland at the socially optimal level, QOPT—that is, $10,000 per acre.

So New Jersey voters are indeed implementing the right policy to raise their social welfare—taxing themselves in order to provide subsidies for farmland preservation.

Positive Externalities in Today’s Economy

A technology spillover is an external benefit that results when knowledge spreads among individuals and firms.

In the overall U.S. economy, the most important single source of external benefits is the creation of knowledge. In high-tech industries such as semiconductors, software design, green technology, and bioengineering, innovations by one firm are quickly emulated and improved upon by rival firms. Such spreading of knowledge across individuals and firms is known as a technology spillover. In today’s economy, the greatest sources of technology spillovers are major universities and research institutes.

In technologically advanced countries such as the United States, Japan, the United Kingdom, Germany, France, and Israel, there is an ongoing exchange of people and ideas among private industries, major universities, and research institutes located in close proximity. The dynamic interplay that occurs in these research clusters spurs innovation and competition, theoretical advances, and practical applications.

One of the best known and most successful research clusters is the Research Triangle in North Carolina, anchored by Duke University and the University of North Carolina, several other universities and hospitals, and companies such as IBM, Pfizer, and Qualcomm. Ultimately, these areas of technology spillover increase the economy’s productivity and raise living standards.

But research clusters don’t appear out of thin air. Except in a few instances in which firms have funded basic research on a long-term basis, research clusters have grown up around major universities. And like farmland preservation in New Jersey, major universities and their research activities are subsidized by government. In fact, government policy makers in advanced countries have long understood that the external benefits generated by knowledge, stemming from basic education to high-tech research, are key to the economy’s growth over time.



The Impeccable Economic Logic of Early-Childhood Intervention Programs

image | interactive activity

One of the most vexing problems facing any society is how to break what researchers call the “cycle of poverty”: children who grow up in disadvantaged socioeconomic circumstances are far more likely to remain trapped in poverty as adults, even after we account for differences in ability. They are more likely to be unemployed or underemployed, to engage in crime, and to suffer chronic health problems.

Early-childhood intervention programs focusing on education and health offer many external benefits to society.
fatihhoca/iStockphoto/Getty Images

Early-childhood intervention has offered some hope of breaking the cycle. A study by the RAND Corporation found that high-quality early-childhood programs that focus on education and health care lead to significant social, intellectual, and financial advantages for kids who would otherwise be at risk of dropping out of high school and of engaging in criminal behavior. Children in programs like Head Start were less likely to engage in such destructive behaviors and more likely to end up with a job and to earn a high salary later in life.

Another study by researchers at the University of Pittsburgh looked at early-childhood intervention programs from a dollars-and-cents perspective, finding from $4 to $7 in benefits for every $1 spent on early-childhood intervention programs, while a Rand study put the figure as high as $17 per $1 spent. The Pittsburgh study also pointed to one program whose participants, by age 20, were 26% more likely to have finished high school, 35% less likely to have been charged in juvenile court, and 40% less likely to have repeated a grade compared to individuals of similar socioeconomic background who did not attend preschool.

The observed external benefits to society of these programs are so large that the Brookings Institution predicts that providing high-quality preschool education to every American child would result in an increase in GDP, the total value of a country’s domestic output, by almost 2%, representing over 3 million more jobs.

Quick Review

  • When there are positive externalities, or external benefits, a market economy, left to itself, will typically produce too little of the good or activity. The socially optimal quantity of the good or activity can be achieved by an optimal Pigouvian subsidy.

  • The most important example of external benefits in an economy is the creation of knowledge through technology spillover.

Check Your Understanding 10-3

Question 10.5

1. In 2013, the U.S. Department of Education spent almost $36 billion on college student aid. Explain why this can be an optimal policy to encourage the creation of knowledge.

College education provides external benefits through the creation of knowledge. And student aid acts like a Pigouvian subsidy on higher education. If the marginal social benefit of higher education is indeed $36 billion, then student aid is an optimal policy.

Question 10.6

2. In each of the following cases, determine whether an external cost or an external benefit is imposed and what an appropriate policy response would be.

  1. Trees planted in urban areas improve air quality and lower summer temperatures.

    Planting trees generates an external benefit: the marginal social benefit of planting trees is higher than the marginal benefit to individual tree planters, since many people (not just those who plant the trees) can benefit from the increased air quality and lower summer temperatures. A Pigouvian subsidy could be placed on each tree planted in urban areas in order to increase the marginal benefit to individual tree planters to the same level as the marginal social benefit.

  2. Water-saving toilets reduce the need to pump water from rivers and aquifers. The cost of a gallon of water to homeowners is virtually zero.

    Water-saving toilets impose an external benefit: the marginal benefit to individual homeowners from replacing a traditional toilet with a water-saving toilet is zero, since water is virtually costless. But the marginal social benefit is large, since fewer rivers and aquifers need to be pumped. A Pigouvian subsidy on installing water-saving toilets could bring the marginal benefit to individual homeowners in line with the marginal social benefit.

  3. Old computer monitors contain toxic materials that pollute the environment when improperly disposed of.

    Disposing of old computer monitors imposes an external cost: the marginal cost to those disposing of old computer monitors is lower than the marginal social cost, since environmental pollution is borne by people other than the person disposing of the monitor. The difference between the marginal social cost and the marginal cost to those disposing of old computer monitors is the marginal external cost. A Pigouvian tax on disposing of computer monitors, or a system of tradable permits for their disposal, could raise the marginal cost to those disposing of old computer monitors sufficiently to make it equal to the marginal social cost.

Solutions appear at back of book.